1. Chapter 7 Currency Options

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To introduce basic concepts. To describe currency options contracts. To identify the determinants of option premiums. To describe exotic currency options.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Definition A currency option is a contract that gives its holder the right to buy and sell, on or by a specified date, an amount of a currency at a predetermined exchange rate.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Options Writers and Holders The writer sells the holder the right to buy or sell the underlying currency. The price paid up front is called the premium.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Payment and Settlement Dates The premium payment date is the date on which the premium is due. The settlement date is the date on which delivery of the underlying currency is required.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Call and Put Options A call option gives the holder the right to buy the underlying currency. A put option gives the holder the right to sell the underlying currency.

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 The Mechanics of Call and Put Options on the Australian Dollar Call (a) Initial exchange Premium (USD) Put Premium (USD) Writer Holder (b) Exercise USD AUD USD Writer HolderWriter Holder Writer Holder

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Naked and Covered Options An option is naked if there is no corresponding spot position on the underlying currency.

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 The Exercise (Strike) Exchange Rate The exchange rate at which the holder of the option can buy or sell the underlying currency

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Profitable Exercise of Call and Put on Currency y y Writer Holder @ E Spot market x y @ S x (a) Call gross profit = S - E Writer Holder @ E Spot market x y @ S x y (b) Put gross profit = E - S

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Profitable Exercise of Call and Put Options on the Australian Dollar AUD 1,000,000 Holder Spot market (a) Call gross profit = USD 50,000 S = 0.65 E= 0.60 Writer AUD 1,000,000 USD 600,000 USD 650,000 AUD 1,000,000 Writer Holder E= 0.60 Spot market USD 600,000 S = 0.55 (b) Put gross profit = USD 50,000 AUD 1,000,000 USD 550,000

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 The Settlement Exchange Rate The exchange rate at which the underlying currency can be bought or sold when the option is exercised

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Net Settlement Payments on Successful Exercise Writer Holder Premium K ( S – E ) (a) Call Writer Holder Premium K ( E – S ) (b) Put

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Long and Short Positions The holder of an option has a long position. The writer of an option has a short position.

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 Expiry Date The date by or on which the option can be exercised

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 American and European Options An American option can be exercised before or on the expiry date. A European option can be exercised on the expiry date only.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 In the Money and Out of the Money An option is in the money if it can be exercised at gross profit. An option is out of the money if it cannot be exercised at gross profit. An option is at the money if the spot rate is equal to the exercise rate.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Intrinsic Value and Time Value The intrinsic value is the extent to which the option is in the money. The time value is derived from the possibility that with the passage of time the option will be in the money.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Assignment An assignment materialises when the writer receives a notice that the holder has exercised the option, in which case the writer is obliged to deliver or receive the underlying currency.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Base and Underlying Currencies The base currency is the currency in which the option price is expressed. The underlying currency is the currency that is bought or sold.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Margins A margin is the cash or securities required to be deposited by an option writer as collateral.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Open Interest Open interest is the number of outstanding options.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Opening and Closing Transactions An opening transaction results in opening a new position. A closing transaction results in liquidating an existing position.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Registered Options Traders ROTs are participants on the exchange, trading for their own or their firm’s account.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Option Quotations American terms mean that the underlying exchange rate is quoted in terms of the US dollar per unit of the other currency. European terms mean that the underlying exchange rate is quoted in terms of the other currency per unit of the US dollar.

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 OTC and Exchange-Traded Options An OTC option is non-standardised, created by the writer to meet the specific requirements of the buyer. An exchange-traded option is a standardised option traded on an exchange.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 Currency Option Specifications Contract size Position limit Base currency Underlying currency Premium quotations

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Gross Pay-offs on Option Positions Long callS - E Long putE - S Short call- (S -E ) Short put- (S -E )

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 Net Pay-offs on Option Positions Net pay-offs take the premium into account. For example, the net pay-off on a long call is: S -E - R

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 Long Straddle Obtained by buying call A and buying put A. It is used when the currency is expected to appreciate or depreciate dramatically.

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Short Straddle Obtained by selling call A and selling put A. It is used when the currency is not expected to move much.

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 Long Strangle Can be obtained by buying call B and buying put A. It is cheaper than a straddle.

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 Short Strangle Can be obtained by selling put A and selling call B.

34. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 Factors Determining Option Prices Exercise exchange rate Time to expiry Intrinsic value Exchange rate volatility

35. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 Factors Determining Option Prices (cont.) Type of option Interest rate on the base currency Forward spread and interest rate differential

36. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 36 Measures of sensitivity Delta:premium with respect to spot exchange rate Gamma:delta with respect to spot exchange rate Theta:premium with respect to time to expiry

37. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 37 Measures of sensitivity (cont.) Vega:premium with respect to volatility Rho:premium with respect to interest rate

38. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 38 Exotic Options Knockout options Path-dependent options Compound options Chooser options