options.ppt by yurtgc548

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									    Foreign Currency Options
• A foreign currency option is a contract 
  giving the option purchaser (the buyer)
  – the right, but not the obligation, 
  – to buy or sell a given amount of foreign 
    exchange at a fixed price per unit 
  – for a specified time period (until the expiration 
    date). 
    Foreign Currency Options
• There are two basic types of options:
  – A call option is an option to buy foreign 
    currency. 
  – A put option is an option to sell foreign 
    currency.

• A buyer of an option is termed the holder; 
  the seller of an option is referred to as the 
  writer or grantor.
    Foreign Currency Options
• There are two basic types of options:
  – A call option is an option to buy foreign 
    currency. 
  – A put option is an option to sell foreign 
    currency.

• A buyer of an option is termed the holder; 
  the seller of an option is referred to as the 
  writer or grantor.
    Foreign Currency Options
• An American option gives the buyer the 
  right to exercise the option at 
  any time between the date of writing 
  and the expiration or maturity date. 
• A European option can be exercised only 
  on the expiration date, not before.
Currency Options Markets
 • December 10th, 1982, the Philadelphia 
   Stock Exchange introduced currency 
   options. Growth has been spectacular. 
 • OTC currency options are not usually 
   traded and can only be exercised at 
   maturity (European). Used to tailor specific 
   amounts and expiration dates.
Philadelphia  Exchange Options
           Philadelphia Exchange Options

          Spot rate, 88.15 ¢/€
    Size of contract:
         €62,500

        Exercise price            The indicated contract price
          0.90 ¢/€                             is:
                                 €62,500 ´ $0.0125/€ = $781.25


            Maturity month
    One call option gives the holder the right to purchase
  One call option gives$56,250 (= €62,500 ´ $0.90/€)
           €62,500 for the holder         Option price for
 the right to purchase €62,500 for        purchase of €1 at
$56,250. This option costs $781.25.         90¢ is 1.25 ¢
   Reading the WSJ Currency 
         Options Table
• The option prices are for the purchase or 
  sale of one unit of a foreign currency with 
  U.S. dollars.  For the Japanese yen, the 
  prices are in hundredths of a cent.  For 
  other currencies, they are in cents.
    – Thus, one call option contract on the Euro 
      with exercise price of 90 cents and exercise 
      month January would give the holder the 
      right to purchase Euro 62,500 for U.S. 
      $56,250.  The indicated price of the contract 
      is 62,500 ´ 0.0125 or $781.25.
• The spot exchange rate on the Euro on 
  12/15/00 is 88.15 cents per Euro.  
 Value of Call Option versus 
Forward Position at Expiration
   A call option allows you to obtain
   only the “nice part” of the
   forward purchase.
       Call Option Value at Expiration
• To summarize, a call option allows you to 
  obtain only the “nice part” of the forward 
  purchase.  Rather than paying X for the foreign 
  currency (as in a forward purchase), you pay no
  more than X, and possibly less than X. 
Option Premiums and Option Writing

• Likewise, a firm that expects to receive 
  future Euro might acquire a put option on 
  Euro.
   – The right to sell at X ensures that this firm 
     gets no less than X for its Euro. 
      
   – Thus, buying a put is like taking out an 
     insurance contract against the risk of low 
     exchange rates. 
Option Premiums and Option Writing 

 • Like any insurance contract, the insured 
   party will pay an insurance premium to 
   the insurer (the writer of the option).
 • The price of an option is often called the 
   option premium and acquiring an option 
   contract is called buying an option.  
 • As with ordinary insurance contracts, the 
   option premium is usually paid up-front. 
    Using Currency Options to 
      Hedge Currency Risk
Suppose you expect to receive 10,000,000 
 euros in 6 months.  Without hedging, your 
 underlying position looks like this
If you also buy a put option with a strike price of .90 for .01, 
           your underlying position looks like this.
            Pricing Options
• Consider a euro call option that has a
  strike price of .90 and that is selling for
  .04.
• If the spot price is .93, the option must be
  worth at least .03. This is called the
  intrinsic value of the option.
• If the option is selling for more than the
  intrinsic value, the difference (in the
  example, .04-.03=.01) is called the time 
  value. We might just as well call it the
                Pricing Options
• Consider a euro call option that has a strike price of .90
  and that is selling for .04.
• If the spot price is .93, the option must be worth at least
  .03. This is called the intrinsic value of the option.
• If the option is selling for more than the intrinsic value,
  the difference (in the example, .04-.03=.01) is called the
  time value. We might just as well call it the hope value,
  since it represents the owners hope that the spot price
  will go up by even more.
  We think about volatility in prices as being a bad thing, and for most 
   financial assets this is true.  A stock whose price fluctuates wildly is 
  less desireable (all other things the same) than a more stable stock.  
    But an interesting thing about options is that their value is actually 
             enhanced by volatility of the underlying asset value.  
• Suppose you owned a euro call option with a strike price of .90.
• Imagine that you thought there was a 50% chance the euro would
    fall to .87 and a 50% chance you thought the euro would increase to
    .93 before expiration of the contract. This means there is a 50%
    chance that you will make .03.
• Imagine now that you changed your mind and decided there was a
    50% chance the euro would fall to .85 and a 50% chance you
    thought the euro would increase to .95 before expiration of the
    contract. You now believe there is a 50% chance you will make .05
    and so you should be willing to pay more for the option.
        Pricing Options: the role of interest rates

•   Consider two different investment portfolios
     – Portfolio “A” consists of 
     – A bond that will pay X at maturity
     – The bond costs X/(1+rus) where rus is the US interest rate
     – A call option with a strike price of X 
     – The option will pay S-X if S>X and 0 if S<X
     – The option costs C
     – Thus
     – If St<X, you get X
     – If St>X, you get St-X+X =St
•   Portfolio “B” is made up by
     – Making a loan of S0/(1+rforeign) units of the foreign currency, 
       where S0 is the current spot rate and rforeign is the foreign interest 
       rate.
     – When the loan matures, you get St units of the domestic 
       currency. A bond that will pay X at maturity
 Conclude:  Portfolio A is better than Portfolio B (A 
never returns less than X and B returns less than X 
                       if St<X)
•   But this implies that B can never sell for more than A
•   That is
•   C+X/(1+rus) > S0/(1+rforeign)
•   or
•   C> S0/(1+rforeign)-X/(1+rus)

								
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