International Financial Markets Options

International Financial Markets: Chapter 5 5-1
WhartonFNCE-219
Professor Amir Yaron
Spring 2014
FNCE-219
International Financial Markets: Options
1. Introduction to Currency Options
1.1 Call Options, put Options, and Option Premia
1.2 Markets for Currency Options
1.3 Intrinsic Value and Time Value
1.4 graphical Analysis of European Options
1.5 Put-Call Parity for European Options
2. Hedging with Options
2.1 Hedging without Eliminating Possible Gains
2.2 Hedging Positions with Reserve Risk
2.3 Hedging non-linear Exposure
2.4 Range Forward and Cylinder Options (Collars)
3. Options Pricing Issues
3.1 Early Exercise and Relative Interest Pricing
3.2 The Black-Scholes Option Pricing Model
3.3 Implied Volatility.
3.4 Speculating with options
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Call Options
A call gives the holder the right to buy a stated number of
underlying assets at a given price (exercise price or strike
price) from the counter party (the writer of the option),
at time T, in the case of a European -style option,
at any time until time T, in the case of an American -style
option.
Example (call)
You buy a call on one CHF at USD/CHF 0.50 expiring on June 30th. You
are long the call.
The counter party is the writer of the call; he has the potential obligation
to deliver one CHF to you at 50 cts if you want him to (that is if you
exercise the option).
If S
T
= USD/CHF 0.60 you will exercise your right and buy CHF at
USD/CHF 0.50, and save USD 0.1.
If S
T
is less than USD/CHF 0.50, i.e 0.48, you will not exercise the option
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Exercise Rules of Call Options
A European call option will be exercised, at T,
iff S
T
-X > 0.
This option allows you to obtain just the "nice" part of the
forward purchase: rather than paying X for sure (as in a
forward purchase), you pay no more than X for the foreign
currency, and possibly less than X.
For early exercise of an American option to be rational, two
conditions must be met:
(S
t
- X) > 0, that is, a positive value dead.
The option's market value (value "alive") is no higher than
the value dead.
) 0 , (
~
X S Max C
T
T
=
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American Option
EXAMPLE
Suppose you have an American option to buy 1 unit of Euro
at X=USD/Euro 0.90.
If S
t
= 0.88, you will not exercise early, you'll wait and
see.
If S
t
= 0.92 but C
t
= 0.04, you are better off selling
than exercising.
Of course, if the option is still alive at T,
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Put Options
Call Option Put Option
Right to buy at FC at X
Useful to hedge a FC debt:
You pay no more than X
C
T
=Max( S
T
X, 0)
Right to Sell FC at X
Useful to Hedge a FC asset:
You get no less than X
P
T
=Max(X- S
T
, 0)
A put is not the short of a call; these are 2 different contracts
A call on Euro in USD is the same as a Put on USD in Euro.
Option Premiums
A call can be used to insure a FC payable against a high S
T
A put can be used to insure a FC receivable against a low S
T
The option buyer pays an (insurance) premium (up front) to buy the option
The option writer gets paid the (insurance) premium, and offers the insurance
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Markets for Currency Options
Traded on organized exchanges (like futures) OR over the counter (OTC)
(like forwards)
Daily transaction volume of $207bn (2010), $212bn (2007), $117bn (2004)
Traded Options
Organized exchanges, with a clearing house as a guarantor party.
Philadelphia Stock Exchange
Expiration dates: third Wednesday of March/June/September/December
+ 2 nearest months.
Contract size: 100K EUR, GDP, CHF, CAD, 1M JPY, cash settled
Price Quotations: Options with new Xs are introduced around the money
as S
t
changes. Prices quoted in cts/FC, for JPY cts/100JPY.
Chicago Mercantile Exchange
Offers options on the foreign currency futures traded at the CME.
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http://www.thestreet.com/video/11500363/introducing-phlx-forex-options.html
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(WallStreetJournal)
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Over the Counter Markets
Majority of currency options, over 90%, are OTC.
Customized options (amount, maturity, exercise price, and type),
usually large amounts in excess of USD 1m. Customization does
not come for free, spreads are higher than for exchange traded
options.
Similar to the spot/forward markets. Banks trade with corporate
customers and hedge their positions in the interbank market.
Interbank trading usually options struck at-the-money-forward.
Options are traded together with spot positions, this keeps
overall positions hedged against exchange rate movements.
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Intrinsic Value and Time Value
Call Put
in the money S
t
X > 0 X S
t
> 0
at the money S
t
X = 0 X S
t
= 0
out of the money S
t
X < 0 X S
t
< 0
Intrinsic value Max(S
t
X,0) Max(X S
t
,0)
Time value C
t
IntVal P
t
IntVal
EXAMPLE: For a call on CHF with strike price X = cts/CHF 43
The intrinsic value is 5 cents if the spot rate is 48 cents. Time value is 1 cent
if the market price is 6 cents.
The intrinsic value is 0 if the spot rate is 40 (or any other price equal to or
below 43). Time value is 2 if market price is 2.
EXAMPLE: Put on CHF at X = 43
The intrinsic value is ... cents if the spot rate is 48 cents. Time value is ...
cents if the market price is 2 cents.
The intrinsic value is ... if the spot rate is 40. Time value is ... if market price
is 5.
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1.4.LowerBoundsonOptionPrices
because
(1) Option have non-negative exercise values (limited liability).
(2) American option gives the holder all the rights of the
European put or call plus the right of early exercise.
C
t
am
> C
t
> 0
P
t
am
> P
t
> 0
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( ) ( )
,0 ,0
am am
t t t t
C Max S X and P Max X S > >
*
,
,
*
,
,
,0
1
1
,0
1
1
am t
t t
t T
t T
am t
t t
t T
t T
S
X
C C Max
r
r
S
X
P P Max
r
r
| |
|
|
|
\ .
| |
|
|
|
\ .
> >
+
+
> >
+
+
(3) American optioncanbeexercisedatanymoment
(4) Europeanoptionisaright,notanobligation,soitisworthatleastas
muchasthecomparableforward purchaseorsale.(Equalityonlyif
exerciseisSURE)
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Suppose F
t,T
= 90cents /FC
Value of forward sale FS
T
= F
t,T
S
T
Value of FC asset = S
T
Value FC asset +forward sale = F
t,T
European Options and Graphical Analysis of
Forward Contracts
S
T
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European Options and Graphical Analysis of
Forward Contracts
Suppose F
t,T
= 90cent $/FC
Value of forward purchase FP
T
= S
T
- F
t,T
Value of FC debt = - S
t
Value FC debt+ forward purchase= - F
t,T
-200
-150
-100
-50
0
50
100
0 50 100 150 200
FC Debt
Forward
Purchase
Hedged Asset
S
T
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Exercise Value of a Call
Call on Euro with strike price X = 35 UScents/Euro
value to holder:
IF S
T
= 32 33 34 35 36 37 38
then C
T
=
value to writer: is just the negative of the value to the holder.
0 0 0 0 1 2 3
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Hence: terminology "minus a call" to describe the writer's
position:
The payoff from a short (or written) call is minus the payoff
from a long position in a call; and
The up-front cash flows also differ by their sign only (the
buyer pays the premium, the writer receives it).
-10
-8
-6
-4
-2
0
2
4
6
8
10
30 31 32 33 34 35 36 37 38 39 40
Buy a call
Sell a Call
S
T
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Exercise Value of a Put
Euro put struck at X = 35 cents:
If S
T
=
32 33 34 35 36 37 38
Then P
T
=
3 2 1 0 0 0 0
-10
-8
-6
-4
-2
0
2
4
6
8
10
30 31 32 33 34 35 36 37 38 39 40
buy a put
sell a put
S
T
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Summary:
Put Option Call Option
Long holder Nice part of a forward Sale Nice Part of a Forward
Purchase
Short Writer Bad Part of a forward Purchase Bad Part of a forward Sale
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Synthetic Forward Sale
Buy a Put and Sell a Call
You Put minus Call at X=35 cents, same T
if S
T
=
32 33 34 35 36 37 38
then P
T
=
3 2 1 0 0 0 0
And - C
T
=
0 0 0 0 -1 -2 -3
Then total: P
T
-C
T
=
3 2 1 0 -1 -2 -3
Equal FS
T
=
3 2 1 0 -1 -2 -3
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-50
-40
-30
-20
-10
0
10
20
30
40
50
0 5 10 15 20 2530 35 4045 50 55 6065 70
buy a put
sell a call
FS
S
T
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Put-Call Parity on European Options
Buying a put and selling a call is a forward sale
buy put sell call forward sale
What implications does this principle have?
Implication 1: You can replicate any of [put, call, FC T-bill, HC T-bill]
using the other three instruments
Implication 2: Law of One Price (Put Call Parity for European
Options): a portfolio of a put minus call must be the same as a
forward sale at X.
T T T S F
~
X,0) - S
~
( Max - ,0) S
~
- Max(X =
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Replication of Instruments
X (a home currency T-Bill with face value X)
X = Max(X - S
T
, 0) - Max(S
T
- X,0) + S
T
With numbers
S
T
=
32 33 34 35 36 37 38
Then P
T
=
3 2 1 0 0 0 0
And -C
T
=
0 0 0 0 -1 -2 -3
Total P
T
-C
T
35 35 35 35 35 35 35
a HC T-Bill with face value X= 35
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(synthetic put = HC T-bill FC debt + call)
(synthetic call = FC T-bill HC debt + put)
(synthetic FC T-bill = HC T-bill put + call)
X,0) - S
~
( Max S
~
- X 0) S
~
- (X Max T T T, + =
-60
-40
-20
0
20
40
60
80
100
120
0 5 10152025303540455055606570
FC Asset Buy a put Sell a call Bond
0) S
~
- (X Max X - S
~
0) X - S
~
( Max T, T , T + =
0) X, - S
~
( Max 0) , S
~
- (X Max - X S T T T + =
S
T
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Put-Call Parity (European Options)
IMPLICATIONS
1. At the forward puts and calls have the same prices
2. At the money puts and calls usually have different
values
3. As soon as we have a Call Option price model, the Put-
Call Parity implies the Put option pricing model.
T t, T t, T t,
T t,
t t
* r 1
St
r 1
X
r 1
F X
C P
+
+
=
+
=
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Put Call Parity for European Options
0
r 1
F - F
) F (X C - ) F (X P
T t,
T t, T t,
T t, t T t, t =
+
= = =
T S
~
At the forward means X=F
t,T
The Forward represents the risk adjusted expected future spot
rate
The value of a bet that a future S
T
will be higher than a CEQ
t
( S
T
) must be equal to the value of a bet that S
T
will be lower.
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At-the-money ( X=S
t
)
If F
t,T
< S
t
FC is at a forward discount. Risk adjusted FC expected to depreciate
Expect the Put to be more valuable
P
t
>C
t
F
t,T
>S
t
FC is at a forward premium, and P
t
<C
t
A bet on an increase of the spot rate is worth more than a bet on a
decrease.
Quick approximate test of Parity for at the money options:
T t,
t
T t, T t,
T t,
t t
* r 1
S
r 1
X
r 1
F X
C P
+
+
=
+
=
r*) (1 r) (1
r * r
S
C P
+ +

=

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Hedging without Eliminating Possible Gains
EXAMPLE
Dozier can buy a put struck at USD/GBP 1.42. If the GBP goes down, Dozier
is hedged. If the GBP goes up Dozier can throw the option away, and benefits
from the rise in the GBP.
0
20
40
60
80
100
120
0 50 100 150
FC Asset Buy a put Hedged Asset
-60
-40
-20
0
20
40
60
80
100
120
0 50 100 150
FC Asset Forward Sale Hedged Asset
S
T
S
T
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Hedging a Position with Reverse Risk
Assume foreign currency cash flows is conditional on other
events
EXAMPLE
Dozier, when making its bid in GBP: inflow of GBP if win, no
inflow of GBP if lose.
Risk of forward hedge: you may have bad news on the other
event and losses on the forward contract.
Advantage of option: avoid having both bad tidings at once.
Example
Dozier, submits bid for GBP 1m. F and X are at USD/GBP 1.47
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Hedge
S
T Wins contract No contract
sell
forward
>1.47
< 1.47
ST+(1.47- ST)=1.47
ST+(1.47- ST)=1.47
0+(1.47 -ST) <0
0+(1.47 - ST) > 0
buy
put
>1.47
< 1.47
ST +(0) > 1.47
ST+(1.47- ST)=1.47
0
(1.47- ST) > 0
-60
-50
-40
-30
-20
-10
0
10
20
30
40
50
0 0.5 1 1.5 2 2.5 3 3.5
buy a put
Sell Forward
S
T
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Barrier Options: Knock-outs
What if you want some protection but find the option premium too
high?
What if you are willing to deal in the spot market if the exchange
rate has moved sufficiently in favor of your original exposure?
Knock-out calls or puts may be appropriate.
A knock-out is an option that ceases to exist if the spot price
touches or goes through a predetermined barrier level (out-strike)
Compared to a vanilla option, the premium of a knock-out is lower,
because there are paths of the exchange rate for which the knock-
out does not pay, but the vanilla option does
If you agree to give up protection along these paths, then the
premium reduction may be worthwhile
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EXAMPLE
Dozier, an American exporter has an accounts receivable in GBP the
current USD/GBP is at 1.45. They can buy a European style put
struck at USD/GBP 1.42, with a knock-out barrier at USD/GBP 1.50.
There are three types of possible outcomes:
1) The spot rate stays below 1.50 and at maturity it is below 1.42:
Dozier exercises the put
1) The spot rate stays below 1.50 and at maturity it is at or above
1.42: the option expires out of the money
2) The spot rate hits 1.50: the option immediately ceases to exist
and Dozier has no more cover
Dozier can now decide whether to:
- forgo cover, and deal at the spot at maturity
- get new cover in the forward market or with a new option
For a 1 year option, the premium would be lowered roughly by
one third in this case
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Hedging Non-Linear Exposure
A companys financial situation may be a non-linear function
of the exchange rate. Options, may then be better suited for
hedging than forwards because of their nonlinear /asymmetric
payoff profiles.
Companies are subject to economic exposure, that is, their
competitive situation and thus their sales depend on the
exchange rate.
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EXAMPLE
Kodak can sell 10m films in the domestic market for USD 3. If
the JPY depreciated below USD/JPY 0.0075 (JPY/USD 133), Fuji
will reduce the price of its films in the American market to S
JPY 400. Kodak will then have to lower its price in step to stay
competitive. Hedge with put
strong yen Value if S > 0.0075
10m films (USD) 30m
Put 4000m JPY X= .0075 0
Total Hedged Position 30m
Weak yenValue if S<0.0075
10m films (USD) 10m( S*400) <30m
Put 4000m JPY X= .0075 4000m(.0075-S)
Total Hedged Position 30m
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0
5
10
15
20
25
30
35
0.0000 0.0025 0.0050 0.0075 0.0100 0.0125 0.0150 0.0175
Sale Receipt Buy a put Hedged Position
-45
-30
-15
0
15
30
45
0.0000 0.0025 0.0050 0.0075 0.0100 0.0125 0.0150 0.0175
Sale Receipt Forward Sale Hedged Position
What would have happened if the hedge had been with forward contracts?
S
T
S
T
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The Use of Options in Risk Management
It is Friday, 10/1/10: Pfimerc has a receivable of 500,000 on Friday, 3/19/11.
Spot (U.S. cents per ): 158.34 Stri ke Cal l Pri ces Put Pri ces
170-day forward rate (U.S. cents per ): 158.05 158 5 4.81
U.S. dollar 170-day interest rate: 0.20% p.a. 159 4.52 5.33
British pound 34-day interest rate: 0.40% p.a. 160 4.08 5.89
Option data for March contracts in /:
How should Pfimerc hedge?
Put Option: gives them the right (but not the obligation) to sell pounds
at a specific price if the 's value falls
Because Pfimerc wants to sell
500,000, it must pay:
500,000 * ($0.0481/) = $24,050

They will exercise if the falls below $1.58/
500,000 * $1.58/ = $790,000 if S(t+170)
$1.58/
They will sell 's in the spot market if the is worth more than $1.58
500,000 * S(t+170) > $790,000 if S(t+170) > $1.58/
Either way, the cost of the put = [$24,050*(1+(0.002*170/360))]=$24,073
The minimum revenue is therefore: $790,000-$24,073=$765,927
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Hedging Pound RevenuesProfit vs. Revenue
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Combinations of Options and Exotic Options
Exotic options - options with different payoff patterns
than the basic options
Range forward contract allows a company to
specify a range of future spot rates over which the
firm can sell or buy forex at the future spot rate
No money up front
Cylinder options allow buyers to specify a desired
trading range and either pay money or potentially
receive money up front for entering into the
contracts
Both can be synthesized
buying a call and selling a put (at a lower X)
For range forward X must be set such that P(X
p
) =
C(X
c
)
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Combinations of Options and Exotic Options
Average-rate options (or Asian option) - most common
exotic option; payoff is max[0, X] where defines
the average forex rate between the initiation of the
contract and the expiration date (source and time
interval are agreed upon)
Barrier options regular option with additional
requirement that either activates or extinguishes the
option if a barrier forex rate is reached
Lookback options option that allows you to buy/sell at
least/most expensive prices over a year (more
expensive than regular options)
Digital options (binary options) pays off principal if X
is reached and 0 otherwise (think lottery)
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RangeForwardsandCylinderOptions(Collars)
Whatifyouwantinsurance,butfindtheoptionpremiumtoohigh?
Whatifyouwanttoinsureagainstlargemovementsintheexchangerate?
Example: Americancompanyhasaccountspayablein3monthstoAustralianfirm.
Contracttobuyforwardonlywhenbigexchangeratechangesfromcurrent
exchangerateS
t
=USD/AUD0.75.
In3months:
ifS
t+1
>0.765, buyAUDatUSD/AUD0.765
if$/AUD0.725<S
t+1
<$/AUD0.765,buyAUDatS
t+1
ifS
t+1
<0.725, buyAUDatUSD/AUD0.725
Tocreatethissyntheticinstrument,
buyacallatX
C
=USD/AUD0.765,and sellputatX
P
=USD/AUD0.725.
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Range Forward: Find call and put with same premium. Chose a ceiling:
call with X
C
= USD/AUD 0.765, the premium is C
t
= $ 0.006.
Now, find a put that has the same premium P
t
= $ 0.006, the strike is X
P
=
USD/AUD 0.725.
The customer locks a maximum exchange rate without having to pay for it.
Cylinder Option: Customer chooses call and put, the premiums do not
need to offset each other, and then either pays or receives the net
difference.
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.6 0.63 0.65 0.68 0.7 0.73 0.75 0.78 0.8 0.83 0.85
sell a put Buy a call
S
T
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S
T
30m
X= .0075
Note:Averagepriceoptions(Asianoptions)maybeparticularly
appropriateforthispurpose
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Exchange-listed currency warrants
Longer-maturity foreign currency options (>1 year)
Issued by major corporations
Actively traded on exchanges such as the American
Stock Exchange, London Stock Exchange, and Australian
Stock Exchange
American-style option contracts
Issuers include AT&T, Ford, Goldman Sachs, General
Electric, etc.
Allow retail investors and small corporations too small to
participate in OTC market to purchase L/T currency
options
Additional Foreign Currency Option Contracts
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Example: Macquarie Put Warrant:
AUD put warrant against $ - maturity date of December 15, 2010
X = $0.90/AUD; multiplier of AUD10
Payoff of put warrant specified in contract as:
Max [0,(X-S)/S]*Multiplier
Suppose spot at maturity is $0.85/AUD, the payoff then is:
([($0.90/AUD) ($0.85/AUD)]/ $0.85/AUD) * 10 = $0.59
Since the actual spot exchange rate at maturity was
$1.0233/AUD, the holder of the warrant at maturity received no
payoff.
https://www.macquarie.com.au/mgl/au/personal/investments/sp
ecialised/listed/trading-warrants
Example: Foreign Currency Option Warrant
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Early Exercise and Relative Interest Rates
What is the value of early exercise on American options?
How likely is early exercise? depends on 2 conditions
(1) Early exercise becomes more likely when options
are deep in the money.
(2) Relative interest rates:
Call: Opportunity cost of not exercising the call, is the foreign
return, r*
t,T
. So, when r*
t,T
is high, early exercise becomes more
likely. Conversely, if r*
t,T
= 0, there is no cost to waiting, and there
would be no early exercise.
Rule-of-thumb: If r* more than 3% p.a. lower than r, then early
exercise for a short-lived call (<9 months) is not likely.
Put: Opportunity cost of not exercising the put, is the domestic
return, r
t,T
. So, when r
t,T
is high, early exercise becomes more likely.
Conversely, if r
t,T
= 0, there is no cost to waiting, and there would be
no early exercise.
Rule-of-thumb: If r is more than 3% p.a. lower than r*, then
early exercise for a short-lived put (<9 months) is not likely.
Option Pricing Issues
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Example: r=9%p.a. r*=12%p.a.
S
t
=USD/GBP1.40 Tt=.25(90daystomaturity)
S:
Inthemoneycalls:nomoretimevaluebelow1.30,withintrinsicvalueSX =
1.401.30=0.10
Inthemoneyputs:mustgomuchdeeperinthemoneyuntilnomoretimevalue:
XS =1.951.40=0.55.
Why?becauser* > r
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The Black-Scholes Option Pricing Model
Black-Scholes model is most widely used option pricing
model. It gives pricing formulas for European options.
Other approaches: Binomial model, numerical approaches.
Assumptions of the Black-Scholes model:
The distribution of percentage changes in the exchange rate
is lognormal (the continuously compounded change in the
exchange rate is normal)
Constant variance of percentage changes of the spot rate
over the options life.
Constant risk free rate(s) over the options life
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Price of European Call:
( ) ( )
T t
T t
T t
T t
T t T t
t
t
d d
X
F
d
d N
r
X
d N
r
S
C
, 1 2
,
,
2 ,
1
2
,
1
,
*

2
1
ln

1
1
o
o
o
=
+
=
+
+
=
whereN(d)denotesthecumulativestandardnormalprobability;o
t,T
isthe
standarddeviationofln().
Standard Notation
C
t
=S
t
e
r*(Tt)
N(d
1
) Xe
r(Tt)
N(d
2
)
( )( ) ( )
( )
( ) t T d d
t T
t T t T r r
X
S
d
t
=

+ +
=
o
o
o
1 2
2 *
1

2
1
ln

T
S
~
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Analyzing the Black-Scholes Formula
Whenvaluingthecall,wehaveinfactcomputedthevalueofaportfolio
containingacertainamountofFCandHCTbills.
ThefirsttermsaysthatonebuysN(d
1
) FCTbills,bypaying
N(d
1
)/(1+r*
t,T
) inFC.
ThesecondtermcorrespondstoasaleofXN(d
2
) indomesticT
bills,atacostofXN(d
2
)/(1+r
t,T
),thatis,onetakesoutaloanforX
N(d
2
)/(1+r
t,T
).
Theideabehindtheformulaisthatthereplicatingportfolioofdomestic
borrowingandforeigninvestmentiscontinuouslyupdated.
( ) ( )
T t T t
t t
r
d N X
r
d N
S C
,
2
,
*
1
1

1

+
+
=
WhartonFNCE-219
N(d
1
)/(1+r
*
t,T
) is the calls delta, because:
that is, if S
t
changes by 1, then C
t
changes by o (for small change in S
t
).
Note: 0 s o s 1
( )

1

,
*
1
T t t
t
r
d N
S
C
+
=
c
c
o
Callpremiumandintrinsicvalue
delta=slope
Option traders can hedge options with cash positions in FC.
Example: Buy call, for GBP 10m, delta = 0.5.
Can hedge call by selling 0.510m= GBP 5m spot;
have a delta neutral position.
WhartonFNCE-219
Standard notational convention for the Black
and Scholes call pricing model:
The convention in the literature and among practitioners is to quote all
data on an annualized basis.
The p.a. variance is typically denoted by the (non-subscripted) symbol
o
2
. Thus o
2
t,T
= o
2
(T-t).
The risk-free rate is typically denoted by the continuously compounded
p.a. interest rate, denoted by the (non-subscripted) symbol r (HC) and
r* for the (FC). Thus: (1+r
t,T
) = e
r(T-t)
&(1+r*
t,T
) = e
r*(T-t)
.
Example
lifeis201days Tt=201/365=0.55
o:volatility14.14% Variance.1414
2
=0.02p.a.
o
2
t,T
=o
2
(Tt)=.02 .55=.011
r(p.a.,cc):9.7347% 1+r
t,T
=e
.0973470.55
=1.055
r*(p.a.,cc):5.9031% 1+r*
t,T
=e
.0590310.55
=1.033
WhartonFNCE-219
Example: Price a Call
S = USD/CHF 0.45, or 45 cents, and X = USD/CHF 0.43, or 43 cents.
Use exchange rates expressed in cents, likewise the Black-Scholes formula
will give an option premium in cents.
Time to maturity: T-t = 201/365 = 0.55
Volatility: o
2
(T-t) = 0.02 0.55= .011, o (T-t) = .1414 0.55 = .10488.
Returns: e
.0973470.55
= 1+r
t,T
= 1.055, and e
.0590310.55
= 1+r*
t,T
= 1.033.
Intermediate calculations:
( )( )
582038 . 0 10488 . 0
686908 . 0
10488 . 0
011 . 0
2
1
066536 . 0
066536 .
43
958 . 45
ln ln
958 . 45
033 . 1
055 . 1
45
* 1
1
1 2
1
,
,
, *
,
= =
=
+
=
= =
= =
+
+
= =

d d
d
X
F
cts
r
r
S e S F
T t
T t
T t
t
t T r r
t T t
WhartonFNCE-219
N(d
1
) = 0.753930, N(d
2
) = 0.719729
Get values from probability table, calculator, or computer.
S
t
e
-r*(T-t)
= S
t
/ (1+r*
t,T
) = 45/1.033 = 43.5624 (cts)
X
t
e
-r(T-t)
= X / (1+r
t,T
) = 43/1.055 = 40.7583 (cts)
C
t
= (43.56240.753930)-(40.75830.719729) = 3.50807 cts.
Note:
Practically, use calculator with option function or software package.
For currency options use the standard Black-Scholes option pricing
model for option on stock paying known dividend yield (also called
Garman-Kohlhagen model). Use foreign interest rate, r*, as the
dividend yield.
WhartonFNCE-219
ThevalueofaEuropeanPutOption
NowthatwehaveapricingequationforaCalloptionwecanusePutCallparity
tofindthepriceofaput:
WhartonFNCE-219
Implied Volatility
Volatility is an important factor determining option premia; the more volatile the
exchange rate, the more valuable the option.
Option buyer can never lose more than the premium paid, yet can realize big gains
on the upside.
The more volatile the asset, the larger the expected gain on the option, so the larger
the premium.
WhartonFNCE-219
An option pricing model can be used to uncover the markets implied
volatility.
In the Black-Scholes model, everything is observed but o. Can use
the formula together with the actual price of the option to uncover
the implied volatility:
C
t
= C(o, S, X, r, r
*
, T-t)
We can reverse this to give: (need numerical methods to find o)
o=G(c,s,x,r,r*,T-t)
Implied Volatility serves as a benchmark for evaluating whether an
option is cheap or expensive
Maps premia into common units
In the interbank markets option prices are mainly quoted in terms of
implied volatility vols, with o
bid
and o
ask
.
WhartonFNCE-219
Different Probability Distributions of Future USD/EUR
k=x=strike price
WhartonFNCE-219
Different Probability Distributions of Future USD/EUR
WhartonFNCE-219
WhartonFNCE-219
WhartonFNCE-219
WhartonFNCE-219
EXAMPLE
Have a March call and a June put option on JPY, trading at
wildly different prices. Are they both correctly priced? Is one
overpriced relative to the other?
Compare their implied volatilities.
EXAMPLE
If think implied o < true o, what to do?
Options are undervalued
Straddle StrategyPayoff when exchange rate moves
significantly up or down
Straddle: buy a put and call
Has to pay premium but since market thinks movement in
S are going to be small, the price will be small.
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.6 0.63 0.65 0.68 0.7 0.73 0.75 0.78 0.8 0.83 0.85
Buy a put
Buy a call
S
T
WhartonFNCE-219
Butterfly
Buy a call at X
c
=0.725
Buy a call at Xc=0.775
Sell 2 calls at Xc=0.750
-0.12
-0.07
-0.02
0.03
0.08
0.675 0.7 0.725 0.75 0.775 0.8 0.825 0.85
Buy a call
Buy a call
sell 2calls
Butterfly
This strategy allows to bet that market perception of volatility is too large
with a limited liability. Loses are kept to initial investment.
Compare to shorting a straddle.
S
T
WhartonFNCE-219
Bullish Spread
Suppose investor thinks call at Xc=0.775 is overvalued
Buy a call at X
c
=0.725
Sell a call at Xc=0.775
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.68 0.705 0.73 0.755 0.78 0.805 0.83
Buy a call
Sell a Call
Bull Spread
The investor is making the bet that?
S
T
WhartonFNCE-219
Bear Spread
Suppose investor thinks Xc=0.725 is overvalued
Sell a call at X
c
=0.725
Buy a call at Xc=0.775
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.68 0.705 0.73 0.755 0.78 0.805 0.83
Buy a call
Sell a Call
Bear
The investor is making the bet that?
S
T

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International Financial Markets: Chapter 5 5-1

International Financial Markets: Chapter 5 5-27

500,000, it must pay:

500,000 * ($0.0481/) = $24,050

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