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  3. Lecture International finance: An analytical approach (3/e): Chapter 10 - Imad A. Moosa

Lecture International finance: An analytical approach (3/e): Chapter 10 - Imad A. Moosa

Chapter 10 - Currency options. In this chapter, the learning objectives are: To introduce basic concepts, to outline the differences between OTC and exchange-traded options, to describe option positions, to identify the determinants of option premiums, to describe exotic currency options. Chapter 10 Currency Options Objectives • To introduce basic concepts • To outline the differences between OTC and exchange-traded options • To describe option positions • To identify the determinants of option

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  1. Chapter 10 Currency Options
  2. Objectives • To introduce basic concepts • To outline the differences between OTC and exchange-traded options • To describe option positions • To identify the determinants of option premiums • To describe exotic currency options Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-2
  3. Definition • A currency option is a contract that gives its holder the right to buy or sell, on or by a specified date, an amount of a currency at a predetermined exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-3
  4. 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-4
  5. 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-5
  6. 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-6
  7. The mechanics of call and put options on the Australian dollar Call Put (a) Initial exchange Writer Holder Writer Holder Premium (USD) Premium (USD) (b) Exercise AUD AUD Writer Holder Writer Holder USD USD Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-7
  8. Naked and covered options • An option is naked if there is no corresponding spot position on the underlying currency Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-8
  9. The exercise (strike) exchange rate • The exchange rate at which the holder of the option can buy or sell the underlying currency Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-9
  10. Profitable exercise of call and put on currency y (a) Call gross profit = S ­ E (b) Put gross profit = E ­ S  y  y  Writer Writer @ E @ E Holder Holder x x @ S y  @ S y  x x Spot  Spot  market market Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-10
  11. Profitable exercise of call and put options on the Australian dollar (a) Call gross profit = USD 50,000 (b) Put gross profit = USD 50,000  AUD 1,000,000 AUD 1,000,000 Writer Writer  E= 0.60  E= 0.60 Holder Holder USD 600,000 USD 600,000 USD 650,000 S = 0.65 AUD  USD 550,000 S = 0.55 AUD  1,000,000 1,000,000 Spot  Spot  market market Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-11
  12. The settlement exchange rate • The exchange rate at which the underlying currency can be bought or sold when the option is exercised Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-12
  13. Net settlement payments on successful exercise Premium (a) Call Writer Holder K ( S – E ) Premium (b) Put Writer Holder K ( E – S ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-13
  14. Long and short positions • The holder of an option has a long position • The writer of an option has a short position Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-14
  15. Expiry date • The date by or on which the option can be exercised Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-15
  16. American and European options • An American option can be exercised before or on the expiry date • A European option can be exercised on the expiry date only Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-16
  17. In the money and out of the money • An option is in the money if it can be exercised at gross profit • An option is out of the money if it cannot be exercised at gross profit • An option is at the money if the spot rate is equal to the exercise rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-17
  18. Intrinsic value and time value • The intrinsic value is the extent to which the option is in the money • The time value is derived from the possibility that with the passage of time the option will be in the money Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-18
  19. Assignment • An assignment materialises when the writer receives a notice that the holder has exercised the option, in which case the writer is obliged to deliver or receive the underlying currency Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-19
  20. Base and underlying currencies • The base currency is the currency in which the option price is expressed • The underlying currency is the currency that is bought or sold Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 10-20
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