IBF Chs 6 and 7 on options

# IBF Chs 6 and 7 on options - L4(Ch6 Currency Options and...

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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 out-of-the-money. If S T \$/£ = \$1.60/£, then Call T \$/£ =0 at-the-money. If S T \$/£ = \$1.75/£, then Call T \$/£ = \$0.25/£ in-the-money.

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Valuation 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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IBF Chs 6 and 7 on options - L4(Ch6 Currency Options and...

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