Forex Investment and Currency Trading

Why Use Options?

• Express a Precise Market View
• Hedge a Specific Exposure: non constant, exposed over a range, currency clauses

• Volatile Forecasted Exposures: Business uncertainty
• Contingent exposures: bid to award

Definition of FX Options

• An option is a financial contract giving the buyer of the derivative, the right, but not the obligation to buy (for Call / Sell for a Put) a specified notional of currency against another one at a specific rate, on a specific date.
• The seller of the option has the obligation to transact on the pre-agreed terms, if the owner exercise the option.
• A rational buyer will only exercise the option if the action is beneficial.
• … compare with a Forward: both parties have the obligation to transact

Options Vocabulary: Call, Put, Vanilla, Premium, Notional, Nominal, Strike, Underlying, Spot, Expiry, Tenor, Exercise, Deliver, Write

FX Call Option

It is the right to exchange 2 Assets at a pre-defined rate, on a given date

A Call on a USD is a Put on JPY …

(*) for European Options
On or Before = American options

Option Premium

• An option is a right, therefore it is an asset, not a liability. The owner of the option would exercise the option if that results in making money, or not exercise it, and in that case no money changes hands. In either case no loss of money ensues to the option holder, therefore an option is an asset.
• Therefore, the client has to pay “something” in order to acquire the asset. The price of the option is called the “premium”.
• Two things can happen to the bank that sells an option:
  • At expiry the option is exercised and the bank loses money
  • At expiry the option is not exercise and there is no cash flow
• On balance, the bank expects to lose some money (probability of exercise times the expected loss). The premium compensates the bank for the expected loss in the future.

Calculation of the Option Premium

• Example: the bank has sold to the client a USD call / JPY put
• So how does a bank calculate the expected loss due to having sold the option?
  • If the bank thinks the call option is in-the-money (i.e., it is going to be exercised), it buys the dollars now, so when the client exercises the bank has the dollars ready for delivery to the client
  • If the option becomes out-of-the-money (i.e., not likely to be exercised), then the bank would get rid of these dollars
• Therefore:
  • If USDJPY rises then the option goes in-the-money, and the bank buys the dollars
  • If USDJPY falls, then the option goes out-of-the-money, and the bank gets rid of the dollars
• By using this “dynamic hedging”, the bank just buys high and sells low: hardly a smart strategy!
• There are two consequences to this:
  • The bank will always have the USD ready to deliver in case the option is exercised
  • The bank is guaranteed to be losing money in the process
• Therefore the bank charges the client the amount of money it expects to lose

Premium of an Option