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Options in General: Definition and Use PDF Print E-mail
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Written by Administrator   
Monday, 13 February 2006
Options are actively used within many companies as a risk management tool and are an important tool in that process. As managers of risk it is important to have a good understanding of options as it applies well to our unique position in the market place.

What is an option? Simply stated, an option is a choice. The buyer of an option acquires the right and not the obligation, to buy or sell an underlying asset under specific conditions in exchange for the payment of a premium. It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to perform.

A call option conveys the right to buy the underlying asset, and a put option gives the buyer the right to sell.

What do each of the option types of trades do for your position?

The following table answers this:

Table 1.  RISK PROFILE

RISK Forwards Calls Puts
  ATTITUDE RISK ATTITUDE RISK ATTITUDE RISK
BOUGHT BULLISH HIGH BULLISH LOW BEARISH LOW
SOLD BEARISH HIGH BEARISH HIGH BULLISH HIGH


Table 2. LIMITATIONS

LIMITATIONS BOUGHT SOLD
PROFIT UNLIMITED LIMITED
LOSS LIMITED UNLIMITED

Basic Glossary

Buyer: The purchaser of an option, also referred to as the option holder.

Seller: One who sells an option, also referred to as the writer or grantor of the option.

Call: An option which gives the option buyer the right to purchase (go long) a particular currency at a specific rate. If the buyer exercises the call option, he will acquire a long currency position and someone who has sold an option will be assigned a short currency position at the same time.

Put: An option which gives the option buyer the right to sell (go short) a currency and someone who has sold an option will be assigned a long currency position at the same time.

Underlying: The currency which the option buyer has the right to purchase (in the case of a call) or sell (in the case of a put).

Strike Price: The rate at which the buyer of a call has the right to purchase a currency and at which the buyer of a put has the right to sell a currency, also referred to as the exercise price. The strike price is determined at the time the option is purchased by the client.

Premium: The "price" of the option, the money the option buyer pays and the option seller receives for the rights conveyed by the option. The premium represents the amount the option buyer can lose.

Exercise: The action taken by the buyer (holder) of an option who wishes to acquire a position in the underlying currency at the option strike price.

Expiration Date: The last day on which an option can be exercised. Options expire on a specific date that is determined by the customer at the time the option is transacted with the bank.

Options Pricing Dynamics

Determining what an option is worth at expiry is easy. It will reflect the money that could be realised by the holder of the option by exercising that option. If that is nothing, then that is the value of the option.

This then highlights further terminology that will prove useful:

Intrinsic Value: The amount of money, if any, that could currently be realised by exercising an option with a given strike price. A call option has a intrinsic value if its strike price is below the spot exchange rate. A put option has an intrinsic value if its strike price is above the spot exchange rate.

In-The-Money: This term is applied to an option that has intrinsic value.

Out-Of-The-Money: A call option is said to be "out-of-the-money" if the underlying spot exchange rate is currently less than the strike price of the option. A put option is said to be "out-of-the-money" if the underlying spot exchange rate is currently more than the strike price of the option. An option that is "out-of-the-money" at expiry will have no value, and the holder of the option will allow it to expire worthless.

At-The-Money: Means that the strike price and the spot exchange rate are the same. Like the "out-of-the-money" option, the holder would allow the option to expire.

In table form:

Table 3.

OPTION TYPE Spot exchange rate is greater than strike price Spot exchange rate is equal than strike price Spot exchange rate is less than strike price
CALLS In-The-Money At-The-Money Out-Of-The-Money
PUTS Out-Of-The-Money At-The-Money In-The-Money

More on Currency Options

In every foreign exchange transaction, one currency is purchased and another currency is sold. Consequently, every currency option is both a call and a put.

An option to buy Australian dollars against United States dollars is both an Australian dollar call and a United States dollar put. Conversely, an option to sell Australian dollars against United States dollars is an Australian dollar put and United States dollar call.

Lets take the example, where an Australian importer has the obligation in three months time to pay US$1,000,000 for a commodity such as soymeal. The importer has a number of alternatives.

a) Remain unhedged and purchase the United States dollars at the prevailing spot rate in three months time.

b) Hedging by buying United States dollars forward;

c) Hedging by using an options strategy

One of the many strategies available to an importer is to buy Australian dollar put /United States dollar call option.

The effect of buying an Australian dollar put is to place a ceiling on the cost of imports without limiting the potential benefit if the spot rate rises. The importer limits the cost to a maximum whilst not limiting the minimum.

An exporter who will be receiving US$1,000,000 in three months time as payment for a commodity has a number of alternatives.

a) Remain unhedged and sell the United States dollars at the prevailing spot rate in three months time.

b) Hedging by selling United States dollars forward;

c) Hedging by using an options strategy

One of the many strategies available to an exporter is to buy an Australian dollar call/United States dollar put option.

The effect of buying an Australian dollar put is to guarantee a minimum payment for the export, whilst not limiting potential gains should the spot rate fall.

More Currency Option Basics

Definition
A currency option is the right - but not the obligation - to buy (in the case of a call) or sell (in the case of a put) a set amount of one currency for another at a predetermined price at a predetermined time in the future.

The two parties to a currency option contract are the option buyer and the option seller/writer. The option buyer may, for an agreed upon price called the premium, purchase from the option writer a commitment that the option writer will sell (or purchase) a specified amount of a foreign currency upon demand. The option extends only until the expiration date. The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price or strike price. The total description of a currency option includes the underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put. There are two types of option expirations - American-style and European-style. American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration only.

Currency options may be quoted in one of two ways: American-terms, in which a currency is quoted in terms of the U.S. dollar per unit of foreign currency; and European-terms (inverse terms), in which the dollar is quoted in terms of units of foreign currency per dollar. The same logic can be applied to currency pairs in which the U.S. dollar is not one of the currencies. Either currency can be expressed in terms of the other.
Option Pricing
The premium quoted for a particular option at a particular time represents a consensus of the option's current value which is comprised of two elements: intrinsic value and time value. Intrinsic value is simply the difference between the spot price and the strike price. A put option will have intrinsic value only when the spot price is below the strike price. A call option will have intrinsic value only when the spot price is above the strike price. Options which have intrinsic value are said to be "in-the-money."

Time value is more complex. When the price of a call or put option is greater than its intrinsic value, it is because it has time value. Time value is determined by five variables: the spot or underlying price, the expected volatility of the underlying currency, the exercise price, time to expiration, and the difference in the "risk-free" rate of interest that can be earned by the two currencies. Time value falls toward zero as the expiration date approaches. An option is said to be "out-of-the-money" if its price is comprised only of time value. A variety of complex option pricing models such as Black-Scholes and Cox-Rubinstein have been developed to determine option pricing. Another commonly used model for currency option valuation is the Garmen-Kohlhagen model. There are many texts available which cover the specifics of option pricing models in detail. Interest rate differentials between nations and temporary supply/demand imbalances can also have an effect on option premiums. In the final analysis, option prices (premiums) must be low enough to induce potential buyers to buy and high enough to induce potential option writers to sell.
Last Updated ( Thursday, 23 February 2006 )
 
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