Currency Options. Meaning of a Currency Option Types of Options Classification of Options Hedging and Speculation Using Currency Options Determining profit/loss.

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Presentation transcript:

Currency Options

Meaning of a Currency Option Types of Options Classification of Options Hedging and Speculation Using Currency Options Determining profit/loss on an option

Currency Options A contract between two parties —a buyer and a seller/writer— in which the buyer purchases from the seller/writer the right to buy or sell a currency at a predetermined exchange rate. The buyer pays the seller a fee called the premium, which is the option’s price. An option to buy an asset at a predetermined price (also known as exercise price) is known as the call option An option to sell as asset at a predetermined price (also known as exercise price) is known as put option

Types of Options European Style It can be exercised at the discretion of the option buyer/option holder only at the maturity of the option American Style It can be exercised at the discretion of the option buyer/option holder at any time before maturity or at maturity of the option

Classification of Options In-the-Money Option One that would lead to positive cash flows to the holder if it were exercised immediately At-the-Money Option One that would lead to zero cash flows to the holder if it were exercised immediately Out-of-Money Option One that would lead to negative cash flows to the holder if it were exercised immediately

In-Money Calls and Puts Call is in the money if S T > E Put is in the money if E > S T Out of Money Calls and Puts Call is out of money if S T < E Put is out of money if E < S T

Strategies Using Currency Options Long a Call Option/Buy a Call Option Buy a right to purchase a foreign currency at a predetermined exchange rate Long a Put Option Buy a right to sell a foreign currency at a predetermined exchange rate

Hedging and Speculation Foreign Currency Cash Outflows Risk: Foreign currency may increase in value against domestic currency Strategy: Buy a call option on the foreign currency Foreign Currency Cash Inflows Risk: Foreign currency may decrease in value against domestic currency Strategy: Buy a put option on the foreign currency