Currency Options

CURRENCY OPTIONS

A currency option is no different from a stock option except that the underlying asset is foreign exchange. The basic premises remain the same: the buyer of option has the right but no obligation to enter into a contract with the seller. Therefore the buyer of a currency option has the right, to his advantage, to enter into the specified contract

TERMINOLOGY OF CURRENCY OPTIONS

•       Call Option: - A call option will have intrinsic value only when the spot price is above the strike price.

•       Put Option: - A put option will have intrinsic value only when the spot price is below the strike price.

•       Intrinsic  Value Of The Option:-  Intrinsic value is simply the difference between the spot price and the strike price.

•       Time Value Of The Option:- When the price of a call or put option is greater than its intrinsic value, it is because of its time value.

•       Strike Price/ Exercise Price:- The price at which a specific derivative contract can be exercised. Strike prices is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold.

•       Maturity / Expiry Date:- The date on which an option expires and after that date the option cannot be exercised.

•       American Option:- An option that can be exercised anytime during its life.

•       European Option:- An option that can only be exercised only after maturity.

Hedging

Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position.

•       For example:- a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position

Valuation Of Options

Because the values of option contracts depend on a number of different variables in addition to the value of the underlying asset, they are complex to value. There are many pricing models in use, although all essentially incorporate the concepts of rational pricing, Moneyness, Option time value and Put-call parity

Determinants Of Valuation Of Currency Option

•       The Spot Exchange Rate.

•       The Strike Or Exercise Price.

•       Time To Maturity.

•       Home Currency Risk Free Interest Rate.

•       Foreign Currency Risk Free Interest Rate.

•       Volatility Of The Spot Exchange Rate.