Vipul Nagda

FX Dealing
Canara Bank
Currency Options
Meaning of a Currency Option
Types of Options
Classification of Options
Hedging 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 options 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 > X
Put is in the money if X> S
Out of Money Calls and Puts
Call is out of money if S < X
Put is out of money if X < S

Exercise or strike Price= X

Spot Price =S
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
For Importers

Foreign Currency Cash Outflows

Risk: Foreign currency may increase in value
against domestic currency
Strategy: Buy a call option on the foreign currency
For Exporters

Foreign Currency Cash Inflows

Risk: Foreign currency may decrease in value against
domestic currency
Strategy: Buy a put option on the foreign currency
Call Option
The Call Option establishes a ceiling for the exchange rate, and
the option can be used to hedge foreign currency outflows
(potential payments)
If S>X
=> Profit increases one-for-one with appreciation of the foreign
currency. At (X+P) the holder of the option breaks even (ceiling
price)
If S<X
=> The call option will not be exercised, because the holder is
better off buying the foreign currency in the spot market. The
holder will have a negative profit reflecting the premium, P
Profit Profile for a Call Option
Profit

S
X X+P

-P
Put Option
The Put Option establishes a floor for the exchange rate, and the
option can be used to hedge foreign currency inflows
If S>X
=> The call option will not be exercised, because the holder is
better off selling the foreign currency in the spot market. The
holder will have a negative profit reflecting the premium, P
If S<X
=> Profit increases one-for-one with depreciation of the foreign
currency. At (X-P) the holder of the option breaks even (floor
price)
Profit Profile for a Put Option
Profit

S
X-P X

-P
Option Pricing
For European options
Black-Scholes pricing model
Garman & Kohlhagen
For both European and American option:
Binomial pricing model
Implicit finite difference method