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Lecture International finance: An analytical approach (2/e) – Chapter 7: Currency options

Lecture International finance: An analytical approach (2/e) – Chapter 7: Currency options. The goals of this chapter are: To introduce basic concepts, to describe currency options contracts, to identify the determinants of option premiums, to describe exotic currency options. | Chapter 7 Currency Options Objectives To introduce basic concepts. To describe currency options contracts. To identify the determinants of option premiums. To describe exotic currency options. Definition A currency option is a contract that gives its holder the right to buy and sell, on or by a specified date, an amount of a currency at a predetermined exchange rate. Options Writers and Holders The writer sells the holder the right to buy or sell the underlying currency. The price paid up front is called the premium. Payment and Settlement Dates The premium payment date is the date on which the premium is due. The settlement date is the date on which delivery of the underlying currency is required. Call and Put Options A call option gives the holder the right to buy the underlying currency. A put option gives the holder the right to sell the underlying currency. The Mechanics of Call and Put Options on the Australian Dollar Call (a) Initial exchange Premium (USD) Put Premium (USD) Writer Holder (b) Exercise USD AUD AUD USD Writer Holder Writer Holder Writer Holder Naked and Covered Options An option is naked if there is no corresponding spot position on the underlying currency. The Exercise (Strike) Exchange Rate The exchange rate at which the holder of the option can buy or sell the underlying currency Profitable Exercise of Call and Put on Currency y y Writer Holder @ E Spot market x y @ S x (a) Call gross profit = S - E Writer Holder @ E Spot market x y @ S x y (b) Put gross profit = E - S Profitable Exercise of Call and Put Options on the Australian Dollar AUD 1,000,000 Holder Spot market (a) Call gross profit = USD 50,000 S = 0.65 E= 0.60 Writer AUD 1,000,000 USD 600,000 USD 650,000 AUD 1,000,000 Writer Holder E= 0.60 Spot market USD 600,000 S = 0.55 (b) Put gross profit = USD 50,000 AUD 1,000,000 USD 550,000 The Settlement Exchange Rate The exchange rate at which the underlying currency can be bought or sold when the option is exercised Net Settlement . | Chapter 7 Currency Options Objectives To introduce basic concepts. To describe currency options contracts. To identify the determinants of option premiums. To describe exotic currency options. Definition A currency option is a contract that gives its holder the right to buy and sell, on or by a specified date, an amount of a currency at a predetermined exchange rate. Options Writers and Holders The writer sells the holder the right to buy or sell the underlying currency. The price paid up front is called the premium. Payment and Settlement Dates The premium payment date is the date on which the premium is due. The settlement date is the date on which delivery of the underlying currency is required. Call and Put Options A call option gives the holder the right to buy the underlying currency. A put option gives the holder the right to sell the underlying currency. The Mechanics of Call and Put Options on the Australian Dollar Call (a) Initial exchange Premium (USD) Put Premium (USD) .