Desktop version

Home arrow Economics arrow Derivative Markets

Options on foreign exchange

Introduction

We repeat our illustration on options introduce deadlier for the sake of orientation (see Figure 18).

options

Figure 18: options

As in the case of bonds and shares, the options market in foreign currency can be divided into the wholesale and retail markets as follows:

• Options on foreign exchange (wholesale).

• Options on foreign exchange (retail: warrants).

Options on foreign exchange (wholesale)

Options on foreign exchange (also called currency options) are traded the world over, and the most tradable contracts are those written on USD / EUR (example: EUR 62 500 on the PHLX), USD / JPY (example: JPY 12 500 000 on the PHLX), USD / GBP (example GBP 31 250 on the PHLX), USD / CAD (example: CAD 50 000 on the PHLX), USD / AUD (example: AUD 50 000 on the PHLX). In the US, the Philadelphia Options Exchange (PHLX) is particularly active in currency options.

The underlying asset in a currency option is an exchange rate. A call option on the GBP for example will give the buyer the right to buy GBP for a given price in dollars (i.e. the strike price).

Calls

Puts

July

August

June

August

1.5

2.4

2.9

1.1

1.55

2.23

1.64

1.3

1.84

2.35

1.5

2.01

2.62

1.65

0.94

1.43

1.89

1.05

2.55

3.21

Table 13: Philadelphia options exchange GBP / USD options GBP 31 250 (cents per GBP) (spot price: GBP / USD 1.6383)

An example is always useful (see Table 13). The GBP / USD spot price is GBP / USD 1.6383. The face value of currency option contracts is fixed at an amount of currency; in this example it is GBP 31 250). A US investor purchases a June GBP call option at an exercise / strike price of 1.63 (this of course means GBP / USD 1.63). The face value of the contract is GBP 31 250.

At the end of the life of the option the GBP increases in value relative to the USD. We assume GBP / USD 1.76. The investor exercises the option and receives GBP 31 250 for which he pays USD 50 937.50 (1.63 x GBP 31 250). The investor sells the GBP in the spot forex market at the spot exchange rate of GBP / USD 1.76, and receives USD 55 000 (1.76 x GBP 31 250). The profit made is USD 4 062.50 (USD 55 000 - USD 50 937.50) less the premium paid for the option.

The premium is quoted in US cents per GBP. In the above example the premium is 1.5 US cents per GBP, i.e. the premium amount is 31 250 x 1.5 / 100 = USD 468.75. Total net profit is USD 3 593.75 (USD 4 062.50 - USD 468.75).

Options on foreign exchange (retail: warrants)

In addition to the wholesale market, there exists a market in retail options on foreign currencies. In some countries these are called currency reference warrants (CRWs).62 CRWs are of the European variety, are available as call and put warrants, are usually listed on the exchange, and are cash settled.

CRWs enable investors to hedge themselves against unexpected movements in the LCC. Call warrants enable investors to buy a foreign currency (i.e. to sell the LCC) when they believe the LCC will weaken (read: pay more LCC for one unit of the foreign currency). On the other hand, put warrants enable investors to sell a foreign currency (i.e. to buy the LCC) when they believe the LCC will strengthen (read: less LCC for one unit of the foreign currency)

Options on commodities

The commodities options markets are also large markets internationally, but they fade into the background when compared with the options on financial instruments markets. Options are written on all the larger commodities, such as gold, oil, wheat, maize, soybean, and certain commodity indices such as the AMEX oil index. The commodity options markets are both formalised and OTC.

In addition to the wholesale options on commodities market, there exists a retail market: warrants on commodities.63 These are called commodity reference warrant (CoRWs) in some countries. The underlying assets of CoRWs are commodities such as gold, platinum, and oil, expressed in LCC. They are available in puts and calls.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >

Related topics