Options

INTRODUCTION

One essential feature of forward contract is that once one has locked into a rate in a forward contract, he cannot benefit from the movement of the market in his favour

Options are unique financial instruments in that they enable the option holder (or buyer of the option) to maximize his profits at the same time limiting his losses. This is possible as options confer upon the holder the right (to buy or sell) without the obligation (to buy or sell)

However, the seller of the option (or the writer of the option) has an obligation to take the other side of the transaction if the buyer wishes to exercise his option.

FUNCTIONAL USE

Options have proved to be a very versatile and flexible tool for risk management in a variety of situations arising in foreign exchange, corporate finance, stock portfolio risk management, interest risk management and hedging of commodity price risk. By themselves and in combination with other financial instruments, options permit creation of tailor made risk management strategies

Options also provide a way by which individual investors with moderate amounts of capital can speculate on the movement of exchanges. The limited loss feature of option is particularly advantageous in this context

DEFINITION

An option contract is defined as an agreement between two parties in which one grants to the other the right to buy (call option) or sell (put option) an asset under specified conditions (price, time) and assumes the obligation to sell or buy it. The party, which has the right, but not an obligation, is the buyer of the option, and pays a fee or premium, to the writer or seller of the option. The asset could be foreign currency, bond, share

TO PUT IT DIFFERENTLY…

An option buyer….(also called a holder) purchase fromAn option writer….(also called grantor or seller)Either a call option…..(the right to buy the currency) orPut option……(the right to sell the currency) On the underlying currency….(the currency) at theAgreed strike price…..(currency exchange rate)For a known expiration cycle….(finite life of the option)With a known expiration date…..(termination of option)For an agreed cash payment….(option premium paid by buyer)

OPTION TERMINOLOGY

Call optionGives the buyer of the option the right to buy a currency

Put optionGives the buyer of the option the right to sell a currency

Strike price

The price specified in the option contract at which the option buyer can purchase or sell the currency.

Maturity dateThe date on which the option contract expires

Exchange traded options have standardized maturity dates

American option Can be exercised at any date before and including the expiry date

European optionCan be exercised only at maturity

Premium

Option price or value – the fee the buyer must pay the option writer ‘up-front’ i.e. at the time the contract is initiated. If the option lapses, unexercised, the buyer loses this amount

At the money - Strike price is equal to currency spot price

In the money - Strike price is favourable to the option buyer compared to the current spot price

Out of money - Strike price is unfavourable to the option buyer in relation to the current spot price

ADVANTAGES

In case the exchange rate moves favourably, the buyer of the option contract ignores his contract and leaves it unutilized and cover at the ruling favourable rate. If the ruling exchange rate is unfavourable the buyer of the option exercises his option. Thus an option contract protects the buyer against movement of exchange rate in one direction at a price (premium, fee paid) but leaves him free to secure the profit arising from movement of the exchange rate in other direction.

OPTION PRICING

The fee paid for buying a put or call option depends upon several factors, as follows, and is comparable to an insurance premium

Call or put, Currency and amount, Strike rate, Style (American or European), Expiration date and time, Spot rate, Interest rates for each currency, FX swap rate and Volatility of currency

The subject of option pricing is a complicated one. However, there are models available for appropriate pricing.

MARKET PLACE

Options are traded in two distinct markets – Over the market and Exchange listed

OVER THE COUNTER

The market participants deal with each other either directly or through an OTC broker. OTC market is therefore not governed by the rules of an exchange, and can therefore quote options in any currency pair, style, amount, date, strike, and premium or rate quotation

EXCHANGE LISTED

All options trading are under exchange rules and rules of the relative clearing house / corporation. All contracts have fixed maturity dates, strikes, currency amounts, style, premium quotation, etc. All exchanges use the margin system to ensure performance of the members and the members use the same system for their members

SPECIAL OBSERVATIONS

Unlike forward contracts, options are expensive. More particularly at the money options are costly compared to out of money options. To overcome this, option combinations comprising calls and puts with different strikes and amounts have been invented primarily for premium reduction to reduce hedging costs.

The simultaneous availability of puts and calls makes for some interesting combinations. There are four basic kinds.

A straddle is a put and a call on the same security / exposure at the same exercise price and for the same time period

A strip is two puts and one call at the same exercise price for the same period.

A spread consists of a put and a call option on the same security/exposure for the same time period at different prices..

A strap is two calls and one put at the same contracted exercise price and for the same period

Most of the option combinations have been created to suit corporate requirements to hedge or manage exposure. The plain call or put option would be suitable for most cases except for the reluctance to pay the premium and it is for this reason that the majority of the combinations are constructed

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