Options

Sergio Rebelo

Northwestern University

April 4, 2011

Sergio Rebelo (Northwestern University) Options April 4, 2011 1/1

Foreign currency options
• A foreign currency option contract gives the buyer of
the option the right but not the obligation to transact
in a specific amount of foreign currency at a given
exchange rate of domestic currency per unit of
foreign currency.

• Call option
– Gives the right to buy a specific amount of foreign
currency with domestic currency at the exchange rate
stated in the contract.

• Put Option
– Gives the right to sell a specific amount of foreign
currency with domestic currency at the exchange rate
stated in the contract.
 Foreign currency options
Terminology
• Exercising the option
– Engaging in the transaction specified in the options contract.
• Option
p p
price or p
premium
– The price that needs to be paid for the right to exercise the option.
• Exercise price or Strike Price
– The exchange rate in the option contract at which the buyer can transact.
• Expiration or Maturity date
– Date by which the option will become worthless if not exercised.
• European Options
– They can only be exercised at maturity.
• American options
– They allow early exercise.
• An option is in the money
– If revenue could be obtained from exercising the option immediately.
• An option is out of the money
– If no revenue could
ld be
b obtained
bt i d from
f exercising
i i the
th option
ti immediately.
i di t l
• An option is at the money
– If the current price coincides with the strike price.
Profit and loss buyer of a call option
(long call position)

• Suppose you buy a call option on Euros with 1 year

maturity and a strike price of $0.80/Euro.
• The
Th option
i sells
ll ffor $0
$0.001/Euro
001/E
• The 1-year dollar interest rate is 10%

Profit in
US$

Profits from Exercising Option

Out of the money At the money In the money

0.80 Spott P
S Price
i
$/Euro
-0.001x(1+.10)

Future value of the price of the option

 Profit and loss, buyer of a call option
(long call position)

Profit in
US$
Out of the money At the money In the money

Unlimited profit

0 80
0.80 0 8011
0.8011 Spot Price
Limited loss $/Euro
-0.001x(1+.10)

Break even price

• The profits at maturity are:

– Zero if S<0.80
S<0 80
– (S - 0.8) if S>0.80
• The break even point is the value of the spot exchange rate (S) such
that these profits compensate exactly the future value of the option
price:
(S-0.8) - 0.001x(1.10) = 0
which implies S = 0.8011
 Profit and loss, writer of a call option
(short call position)

• Suppose you write (sold) a call option on Euros

with 1 year maturity and a strike price of
$0.80/Euro.
• The option sells for $0.001/Euro
• The
h 1-year dollar
d ll interest rate is 10%

Profit in
US$

0.001x(1+.10)
Li it d profit
Limited fit

0.80 0.8011 Spot Price

$/Euro
Unlimited loss

Break even price

 Profit and loss, buyer of a put option on
Euros ((long put position)
Profit in
US$
0.7989 In the money At the money Out of the money

Potential net profit

up to $0.7989/Euro

0.7989 0.80 Spot Price

Limited loss $/Euro
-0.001x(1+.10)

Break even price

• The
e profits
p o s ata maturity
a u y are:
a e
– (0.8-S) if S<0.80
– Zero if S>0.80
• The break even point is the value of the spot exchange rate (S) such that these
profits compensate exactly the future value of the option price:
(0 8 S) - 0.001x(1.10)=0,
(0.8-S) 0 001 (1 10) 0
which implies S = 0.7989
• Maximum net profits occur when S=0 and equal 0.8-0.001x(1.10)=0.7989
Profit and loss, writer of a put option on Euros
(short put position)

Profit in
US$

0.001x(1+.10)
Limited profit
0.7989

Potential net loss 0.80 Spot Price

up to $0.7989/Euro $/Euro

Break even price

-0.7989
Hedging with options
E
Example
l 1

• An exporter
p from the U.S. to the U.K. has
an account receivable of 500,000 British
Pounds due in 30 days.

• Data:
– Spot Rate ($/BP) 1.5392
– 30-day Forward Rate ($/BP): 1.5292
– U.S. dollar 30 day interest rate: 3.75% p.a.
– British pound 30-day
30 day interest rate: 6.65%
6 65% p.a.
pa
– Pound European Put Option (maturity 30 days):
cost 2.28 cents per pound with a strike price of
$1 525/BP
$1.525/BP
 Hedging with options
Example 1
$ Unhedged Value of 0.5M £ Put Option on the Pound
$
Strike price

$762,500 0
$1.525
($/ £))
St+30 ($
-$11,435.6

0
t 30 ($/ £)
$1.525
$ St+30
$ Hedged Position = Unhedged Position +
Put Option

$751,064

0 St+30 ($/ £)
$1.525
Hedging with options
Example 1

Revenue
in US$
Position hedged with put options

$764,600 Position hedged with forward

contract

$751,064

1.5250 Spot Price

$/BP

Option strike price

 Put-call-forward parity for European currency options
Apparticular case

• Let’s try to build a synthetic forward combining two options with a strike
price
i equall tto th
the fforward
d rate
t

• Options Portfolio Cash Flow Cash Flow in Period 1

Period
d0 iff S1<=F iff S1>=F
– Buy Call -C 0 S1 - F
– Sell Put +P S1 - F 0
– Sum of Above -C + P S1 - F S1 - F

C = price of call option S1 = spot exchange rate in period 1

P = price of put option F = forward rate

S and F represent domestic currency/units of foreign currency

 Put-call-forward parity for European currency options
A particular case
• Options Portfolio Cash Flow Cash Flow in Period 1
Period 0 if S1<=F if S1>=F
– Buy
B Call
C ll sell
ll Put
P t -C
C+P S1 - F S1 - F

• Notice that if you hold this portfolio you will buy foreign currency forward
at price F regardless of the value of the future spot rate.
rate The only
difference between the payoffs to the option portfolio and the payoffs to
the forward contract is the -C + P payment at time zero.

• Forward Contract Cash Flow Cash Flow in Period 1

(buy foreign currency) Period 0 if S1<=F if S1>=F
0 S1 - F S1 - F

S and F represent domestic currency/units of foreign currency

 Put-call-forward parity for European currency options
Apparticular case

• The options portfolio allows us to buy foreign currency forward at rate F.

To construct an arbitrage operation let us at the same time sell foreign
currency through a forward contract.

Cash Flow Cash Flow in Period 1

Period 0 if S1<=F if S1>=F
– Buy Call sell Put -C + P S1 - F S1 - F
– Sell Foreign Currency Forward F - S1 F - S1
– TOTAL -C + P 0 0

• To Avoid Arbitrage: P=C

S and F represent domestic currency/units of foreign currency

Put-call-forward parity for European currency options
Apparticular case

Profit
$/Euro

Spot Price
ce
F
$/Euro

Forward contract
Put-call-forward parity for European currency options
Apparticular case

Profit
$/Euro

Sell Put Option

F
Spot Price
$/E
$/Euro
-C

Buy Call Option

Put-call-forward parity for European currency options
Apparticular case

Profit
$/E
$/Euro

Revenue from exercising the call option

Sell Put Option

F
Spot Price
$/Euro
-C
Cost of the call option

Buy Call Option

Put-call-forward parity for European currency options
Apparticular case

Profit
$/Euro

Revenue from exercising the call option

Sell Put Option

Revenue from selling the put option

P

F
Spot Price
$/Euro
-C
Cost of the call option

Buy Call Option

Loss from exercise of put option

Put-call-forward parity for European currency options
Apparticular case

Profit
$/Euro

Revenue from selling the put option

P

F
Spot Price
$/Euro
-C
C
Cost of the call option
Put-call-forward parity for European currency options
Apparticular case

Profit
$/Euro

Sell foreign currency forward

Revenue from selling the put option

P

F
Spot Price
$/Euro
-C
Cost of the call option
Put-call-forward parity for European currency options
Apparticular case

Profit
$/Euro

Revenue from selling the put option

P

F
Spot Price
$/Euro
-C
C
Cost of the call option
 Put-call-forward parity for European currency options
The general case

• Options Portfolio Cash Flow Cash Flow in Period 1

Period 0 if S1<=K if S1>=K
– Buy Call -C 0 S1 - K
– Sell Put +P S1 - K 0
– Sum of Above -C + P S1 - K S1 - K

• Notice that if you hold this portfolio you will buy foreign currency forward
at price K regardless of the value of the future spot rate.

C = price of call option S1 = spot exchange rate in period 1

P = price of put option R = domestic interest rate
K = exercise price R* = foreign interest rate

S and F represent domestic currency/units of foreign currency

 Put-call-forward parity for European currency options
The general case

• Options Portfolio Cash Flow Cash Flow in Period 1

Period 0 if S1<=K if S1>=K
– Buy Call, Sell Put -C + P S1 - K S1 - K
– Sell Foreign Currency Forward F - S1 F - S1
– TOTAL -C + P F-K F-K

• To prevent arbitrage: (P-C) + (F-K)/(1+R) = 0

S and F represent domestic currency/units of foreign currency

 Put-call-forward parity for European currency options
The general case

(P-C)(1+R) + F-K = 0
Difference between
Diff b t the
th price
i att which
hi h currency is
i bought
b ht forward
f d
Profit from selling put and buying call through the outright forward (F) and the options portfolio (K)
(can be positive or negative) (can be positive or negative)

C = price of call option S1 = spot exchange rate in 1

periods
P = price of put option R = domestic interest rate
K = exercise price

S and F represent domestic currency/units of foreign currency

Put-call-forward parity for European currency options
The general case

• Put-Call-Forward Parity C - P = (F-K)/(1+R)

• Covered Interest Parity: (1+R) = F(1+R*)/S

• Put-Call Parity P - C = K/(1+R) - S/(1+R*)

S and F represent domestic currency/units of foreign currency

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Implied volatility

At the money
vols (%)
EUR/USD 1 month 10.7
EUR/USD 12 months 12.3
EUR/GBP 1 month 9.9
EUR/GBP 12 months 11.9
USD/JPY 1 month 10.9
USD/JPY 12 months 13.1
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