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L4: (Ch6) Currency Options and Options Markets
Options Contracts: Preliminaries
An option fives the holder the right, but not the obligation, to buy or sell a given
quantity of an asset in the future, at prices agreed upon today.
European
options can only be
exercised
on the
expiration
date
American
options can be exercised
any
time
up to and including the
expiration date. (thus more time value = more expensive, other things equal)
In the money, at the money, out of the money.
Type of Currency options
A
currency
call
option is the
right
to
buy
the underlying currency at a specified
price on a specified date. Where as, a
currency put
option is the
right to sell
the underlying currency at a specified date.
Payoffs of Currency options
Payoffs of a
call
option:
Call
T
$/£
= max[ S
T
$/£
 K
T
$/£
, 0 ]
Payoffs for a
put
option:
Put
T
$/£
= max[ K
T
$/£
 S
T
$/£
, 0 ]
Example
Suppose GM purchase pound call options with exercise price $1.60/£ which
expires on August 1
st
2010, what will be the option payoffs if exchange rate
moves to $1.20/£, $1.60/£, $1.75/£, a year later?
If
S
T
$/£
= $1.20/£, then
Call
T
$/£
=0
outofthemoney.
If
S
T
$/£
= $1.60/£, then
Call
T
$/£
=0
atthemoney.
If
S
T
$/£
= $1.75/£, then
Call
T
$/£
=
$0.25/£
inthemoney.
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View Full DocumentValuation of Option Contracts
Option Premium
Currency call and put options are not free; Option sellers such as CME of ASX
demand an
option premium
for writing an option, which is also known as
option price
.
Determining the Option Premium
Option value =
intrinsic value
+
time value
Intrinsic value = value if exercised immediately
difference between the
exercise price and the value of the underlying asset.
Time value = additional value prior to exercise
market value
minus
intrinsic
value.
The
time value
of a currency option is a
function
of the following
six
determinants
:
Exchange
rate
underlying the option
Exercise
price
or strike price
Riskless
rate
of interest id of the currency d
Riskless rate of interest if in the currency f
Volatility
in the underlying exchange rate
Time
to expiration
With the exception of volatility, each of these determinants of option value are
readily observable for currency options quoted on major exchanges. The volatility
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 Three '11
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 Options

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