Presentation3 Very Imp

FX, Derivatives and DCM workshop I

Introduction to Options


What is a Currency Option Contract?

• 100% protection• 100% participation

“A financial agreement giving the buyer the right(but not the obligation)

to buy/sell a specified amount of currency at a specified rate on a specified date”


How does it compare to the Forward?

• 100% protection• 0% participation

“A financial contract whereby the owner has the obligationto buy/sell a specified amount of currency at a specified rate

on a specified date”


Definitions

• The right to buy a specified amount of currency at a specified rate

• The right to sell a specified amount of currency at a specified rate

• The price of an option

• The rate at which the right can be exercised

• The date at which the right can be exercised

Call Option

Put Option

Premium

Strike

Expiry Date


Types of Options

• OTC Options

• Listed Options

European styleOption

American styleOption

Option only exercisable on the expiry date

Option exercisable at any time until expiry

Chicago IMM, Philadelphia


Terminology

Unlike futures and forward positions, you have to pay for an option. The amount you pay is known as the “Option Premium”

The “Intrinsic value” of an option is how much you could get from exercising the option immediately. An American option premium, of course, will always at least as great as the option’s intrinsic value. The different between the option premium and the intrinsic value is known as the “Time Value”


Term – Cont’d

• An Option is “in-the-money” if its intrinsic value is positive, and “out-of-the-money” otherwise. An at-the-money option is one with a strike price close to the underlying asset price.


Hedging:

• Option can be used as investments, or to hedge the downside risk of an existing foreign currency exposure. In both cases, it is common to work with “payoff diagram”, which show what is the terminal payoff from holding a (European) option conditional on where the spot exchange rate ends up. That terminal payoff depends upon whether the spot exchange rate ends up above or below the strike price, and whether the option is a call or put.


Hedging – Cont’d

• Buying options can offset the downside foreign currency risk of a position, while retaining the upside potential – at a cost. Options are “insurance” against bad realizations of the exchange rate.

• Buying call options ensures the right to acquire foreign currency at a prespecified price (e.g., to pay off a future liability), while allowing you to forego that right if you can get a cheaper price in the spot market.


Hedging – Cont’d

• Buying put options ensures the right to sell foreign currency (future accounts receivable) at a prespecified price, while allowing you to sell at a higher price in the spot market if chance premits.


• The buyer of an option has the right but not the obligation to perform

• Unlike the long futures strategy, the long call strategy has an asymmetric payoff

• The upside potential, however is less than that for a futures strategy by an amount equal to the option price

profit

loss

Long futures

Long call

Futures price

Option VS Futures (FWD)


Shortfutures

loss

profit

Longfutures

rights

obligations

longput

Longcall

Onlyrights

price

Option buyers

Shortput

shortcall

Onlyobligations

Option sellers

profit

loss

Right VS Obligation


The Four Basic Option Payoffs

• Thus, the four basic option positions - buy a call, sell a call, buy a put, sell a put - can be summarized using a diagram:

BUYCALL

BUYPUT

SELLCALL

SELLPUT


What would an importer do?

Underlying exposure is to pay suppliers USD (Short USD)

To hedge this exposure, an importer needs to buy USD sell THB

Buy USD Call THB Put“at expiry, an importer has theright to buy USD and sell THB”

Sell USD Put THB Call“at expiry, an importer has the

obligation to buy USD and sell THB”


Buy European USD Call

European style USD Call/THB PutSpot 43.00

Strike 43.50

Expiry 3 months

Amount USD1,000,000

Premium 0.30

THB/USD Spot at Expiry

> Strike: Option is exercised (value date = spot date)

= Strike: Option expires withoutvalue

< Strike: Option expires withoutvalue


Spot at expiry

Upfront Premium

100% protectionabove 43.50

100% participationbelow 43.50

P&L

P/L at Expiry (Buy European USD Call)

43.50(Strike)

43.80


Sell European USD Put

European style USD Put/THB CallSpot 43.00

Strike 42.50

Expiry 3 months

Amount USD1,000,000

Premium 0.30


> Strike: Option expires withoutvalue


< Strike: Bank exercises option(Granter inherits OTM position)


P/L at Expiry (Sell European USD Put)

P&L

Spot at expiry

Upfront Premium

42.20

42.50(Strike)


What would an exporter do?

Underlying exposure is to receive USD (Long USD)

To hedge this exposure, an exporter needs to sell USD buy THB

Buy USD Put THB Call“at expiry, an exporter has theright to sell USD and buy THB”

Sell USD Call THB Put“at expiry, an exporter has the

obligation to sell USD and buy THB”


Buy European USD Put

European style USD Put/THB CallSpot 43.00

Strike 42.50

Expiry 3 months

Amount USD 1,000,000

Premium 0.30


> Strike: Option expires withoutvalue


< Strike: Option is exercised (value date = spot date)


P/L at Expiry (Buy European USD Put)

P&L

Spot at expiry

Upfront Premium

100% participationabove 42.50

100% protectionbelow 42.50

42.50(Strike)

42.20


Sell European USD Call

European style USD call/THB PutSpot 43.00

Strike 43.50

Expiry 3 months

Amount USD1,000,000

Premium 0.30


> Strike: Bank exercises option(Granter inherits OTM position)


< Strike: Option expires withoutvalue


P/L at Expiry (Sell European USD Call)

P&L

Spot at expiry

Upfront Premium

43.80

43.50(Strike)


Call - Put Parity

• From the diagram, we can see that:

Long Forward = Long Call + Short Put

Note: it holds only for European options of the same strike


RISK/REWARD CHARACTERISTICS



• The figures illustrate two of the most important characteristics of options:– buyer of options have limited risk and potential

unlimited reward.– sellers of options have limited reward and potential

unlimited risk.• So what will you do? Buy or sell..



• You may realize that almost any trade in stock or futures market carries unlimited risk.

• The limited or unlimited risk/reward characteristics of a trade are not the only considerations. At least as important is the probability of that unlimited profit or loss.



• Buying an option does not lead to a guaranteed gain, once the premium is taken into account.

• If fairly priced, no single option can dominate any other option for all possible future outcomes.


Exercise

Spot = 105.00Buy $1 1-month 110 $ callSell $1 1-month 115 $ callBuy $1 1-month 120 $ call

• What is the payoff diagram (hockey stick)?• Can the structure be zero cost?


P/L Diagram

0 105 110 115 120


P/L Diagram

0 105 110 115 120


DIRECTION UNDECIDED ANDISING VOLATILITY

– long straddle: Buy a call and buy a put with same strike, same maturity, and same amount.

– Long strangle: Buy a put (lower strike) and buy a call (higher strike), with same maturity and same amount.

spot

P/L

P/L

spot

Long strangle

Long straddle

X1 X2

X


Butterfly

• Buy a straddle and sell a strangle with same notional and maturity

P/L

X2

X3X1


Risk Reversal

• Buy a low delta $ call (put) and sell a low delta $ put (call)– e.g. Buy $1 mio 1-month 40 $ call

Sell $1 mio 1-month 38 $ putP/L

39 4038


Some principals

• The larger the potential positive payoff, the more expensive the option strategy

• the way to reduce up-front cost is – reduce the potential positive payoff – increase the potential negative payoff – change the notional amount


BULLISH AND UNDECIDED VOLATILITY

• Bull spread– Buy a call (X1) and sell a call (X2), with X1 < X2

– Buy a put (X1) and sell a put ((X2), with X1 < X2

P/LBull spread

X1 X2


BEARISH AND UNDECIDED VOLATILITY

• Bear spread– Sell a call (X1) and buy a call (X2), with X1 < X2

– Sell a put (X1) and buy a put ((X2), with X1 < X2

P/LBear spread

X1 X2

Business

Presentation3 Very Imp