Application

In spite of the fact that currency options are becoming more and more popular, there is still some client resistance to using currency options to manage currency exposure. Some clients consider currency options t be expensive and / or speculative. More sophisticated clients have, however, made options an important part of their forex exposure management strategies, just like us here at Mandus Invest SA.

When you buy an option, the most you can lose is the premium or price you paid for the currency option. In some cases, currency options can help minimize downside risk, while allowing participation in the upside potential.

Clients who buy currency options enjoy protection from unfavourable exchange rate movements and may benefit from favourable exchange rate movements. Currency options can also be used to hedge different types of exposures or use as a tool to enhance yield. Sometimes, a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost currency option strategy by trading off the premium spent on buying a currency option with the premium earned by selling a currency option.

Buying currency options may assist a client by:

Selling currency options may assist a client by:

Brief history

The currency options market shares its origins with the new markets in derivative products, which have blossomed in the past fifteen years, or so. They were developed to cope with the rise in volatility in the financial markets worldwide. In the foreign exchange markets, the dramatic rise (1983 to 1985) and the subsequent fall (1985 to 1987) in the dollar caused major problems for Central Banks, corporate treasurers, and international investors alike. Windfall forex losses became enormous for the treasurer who failed to hedge, or who hedged too soon, or who borrowed money in the wrong currency. The investor in the international bond market soon discovered that the risk on their bond position could appear insignificant relative to their currency exposure.

Therefore, currency options were developed, not as another interesting off-balance sheet trading vehicle but as an alternative risk management tool to the spot and forward forex markets. They are a product of currency market volatility and owe their existence to the demands of foreign exchange users for alternative hedging and exposure management techniques.

Characteristics

Currency options are not merely insurance contracts against exchange risk but they are above all financial assets that can be bought and sold just like tradable securities. Options may be combined so that their asymmetric payouts tailor a defined risk profile. Some combinations are primarily trading strategies, but option combinations can also be a useful tool. For example, for investors to construct a strategy allowing them to take advantage of a particular view that they have about a market direction. Other strategies allow purchasers to give up some of the benefits they may have received in market movements in return for a reduced premium payment. In our case, at Mandus Invest SA we use currency options as a stop-loss measure.

The market today is characterised by:

Conclusions

Currency options are not merely insurance contracts against foreign exchange risk but they are above all financial assets that can be bought and sold just like tradable securities. Options may be combined so that their asymmetric payouts tailor a defined risk profile. Some combinations are primarily trading strategies, but option combinations can also be a useful tool. For example, for investors to construct a strategy allowing them to take advantage of a particular view that they have about a market direction. Other strategies allow purchasers to give up some of the benefits they may have received in market movements in return for a reduced premium payment. It must be remembered that by buying a call and simultaneously selling a put with the same maturity date and the same strike is equivalent to entering into a forward contract.

But above all, remember the following risk profile of options:

Definitions

The most important factor of an option, in comparison to a foreign exchange transaction, is that the buyer has the right but not the obligation to buy or sell a specified quantity of a currency at a specified rate on or before a specified date. For this right, the buyer pays a premium to the seller or writer of the currency option, usually at the outset. For currency options, the premium is often expressed as a percentage of the notional amount covered.

The terms used in the options market can be confusing, but the principle terms or jargon used can be summarised as:

It is important to note, that due to the nature of foreign exchange, all currency options are a put on one currency and a call on another. For example, a dollar call / Swiss franc put gives the buyer the right to buy dollars and the right to sell Swiss francs.

Market Conventions

How should one ask for an option price? The required pieces of information, in the preferred order, are as follows:

There are many ways of stating the period, but usually, if one date is stated, it is assumed to be the expiry date but it is much safer to always specify. In the same way, if a ten day option is requested, it is assumes that the required option has an expiry date ten days from the current date. If, however, an option is requested with a period in terms of months or years, e.g. three months, the dates of the option are worked out as follows:

This gives the delivery date. The expiry date will then usually be two working days before that. Please note: With cross currencies and dates involving American holidays or in any case where there may be confusion, it is always best to quote both the expiry and delivery dates required.

In asking for an option price, always state which currency is the call and which is the put. For example, does dollar Swiss franc (usd/sfr) put mean a dollar put or a Swiss franc put? This would usually refer to a Swiss franc put dollar call. However, most clients would probably mean a dollar put. For this reason, always state the case in full, e.g. dollar call Swiss franc put or vice versa.

What does a ‘live price’ mean? The price of an option is obviously dependent on the spot price in the market. As an option trader needs to delta hedge the option straight away, the spot at which the trader can hedge is the rate the trader uses to price the option. If a price is being quoted live it means that the person asking for the price will be quoted a premium price for the option and the option trader will take the risk that spot moves during the transaction. The alternative to dealing live is to deal ‘with delta’. This means that the person asking the price will deal the delta hedge with the option trader as well as the option.

How is the premium normally quoted? Normally, the premium is quoted as a percentage of the base currency amount of the option. However, in the interbank market, it is normally quoted as pips per currency amount of the option. For example, if the option is a dollar/ Swiss franc option, the premium can be quoted in the following ways:

If the option were being dealt in a round amount of dollars, e.g. ten million dollars, then either 1) or 3) would be the usual quote. If 2) or 4) were required, however, the Swiss franc amount of the option is found by multiplying the dollar amount by the strike of the option.

Parties Involved

There are two parities involved in currency options: the option buyer and the option seller. The following grid outlines a risk profile for each:

» The option buyer has the right to demand fulfilment of the currency option contract, as they adcan exercise the option and they pay a premium for that right

» The option seller (or writer) grants the right and receives a premium for accepting the trobligation to fulfil the currency option contract, if the buyer demands

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