Currency Options

Question 1

Define an option

Answer 1

• A foreign currency option contract:
  
  • gives the buyer of the option the right, but not the obligation,
  • to trade a specific amount of foreign currency
  • at a specific exchange rate (the strike price)
  • at specific points in time (American or European option).
• The seller must take the other side of the transaction
• The amount the buyer has to pay for this privilege is the options price (the option premium)

Question 2

What are the two fundamental types of options?

Answer 2

call options

put options

Question 3

Explain a call option

Answer 3

A foreign currency call option gives the buyer the right, but not the obligation, to buy a specific amount of foreign currency with domestic currency at an exchange rate stated in the contract.

Question 4

Explain a put option

Answer 4

A foreign currency put option gives the buyer the right, but not the obligation, to sell a specific amount of foreign currency for domestic currency at an exchange rate stated in the contract.

Question 5

When would the buyer exercise a call option?

And why?

Answer 5

1) she would only exercise a call option if the strike price is below the current spot exchange rate.
2) She can buy the currency cheaper in the spot market if the spot rate is lower than the strike price

Question 6

Illustrate and explain the Option payoffs for Long call

Answer 6

Question 7

Illustrate and explain the Option payoffs for Long put

Answer 7

Question 8

Illustrate and explain the Option payoffs for short call

Answer 8

Question 9

Illustrate and explain the Option payoffs for Short put

Answer 9

Question 10

What does moneyness mean?

Answer 10

Options are often characterized by their moneyness in practice.

Moneyness just describes if an option has intrinsic value already, is close to having intrinsic value, or not

1. If some revenue can be earned from (hypothetically) executing the option immediately, the option is said to be “in-the-money” (ITM)
2. If the no revenue can be earned from immediate execution, the option is said to be “out-of-the-money” (OTM).
3. If the strike price and current exchange rate are equal, the option is said to be “at-the-money” (ATM).

Question 11

What is the lowest value of an option?

Answer 11

Option premia are never negative, because the payoffs from an option can never fall below zero.

Moreover, option prices usually have a positive price before maturity, because there is almost always a positive probability that the exchange rate changes in a way that makes the option move into the money.

Hence, even an OTM option with no intrinsic value will have a positive price which is based entirely on the chance of a favorable exchange rate movement in the future. In option jargon, this is called the time value of an option

–> Option value = Intrinsic value + Time value

Question 12

A Japanese speculator buys JPY/USD put options (European style) with strike X=JPY/USD 100, contract size USD 10m, and pays a premium of JPY/USD 5.

What is the revenue and profit for alternative spot exchange rates at expiration of the put?

Answer 12