A Currency option also FX, or FOREX option is a financial product called a derivative where the value is based off an underlying instrument, which in this case is a foreign currency. FX options are call or put options that give the buyer the right not the obligation to buy call or sell put a currency pair at the agreed strike price on the stated expiration date.
FOREX option trading was initially conducted only by large institutions where fund managers, portfolio managers and corporate treasurers would offload risk by hedging their currency exposure in the FX option market. However, currency options are now very popular amounst retail investors as electronic trading and market access is now so widely available. However, many retail online brokerage firms as well as larger institutions provide electronic access to FOREX liquidity pools that also include the trading of currency options online.
Many of the options traded via these firms are still considered OTC as the trader customer transacts directly with the broker, rather than matching the order with another trader.
In this case the broker becomes the counter party to the currency option and hence has to wear the risk. This also means that currency options can be catered to the individual trader. Not all electronic trading destinations for currency options are OTC though.
There are firms that provide liquidity pools for institutions to transact with one another often called Dark Pools. These products will also be accessible by most retail online FX option brokers. I would say that there are two types of risk present when trading foreign exchange options: That is, the risk that the firm that holds the other side of the transaction goes bust, along with any financial obligation to deliver foreign currency.
Counterparty risk is more present in currency options than stock or futures options because there is no central clearing house to protect option traders when the dealer is unable to meet the exercise obligations. In terms of market risk, FX options are more sensitive to macroeconomic factors than stock or futures options. Stock options on the other hand, while still affected by macro economic conditions, are also influenced by company specific variables such as earnings reports, downgrades, sector sentiment etc.
Like an equity option, currency options can be priced using a standard black and scholes option model with a dividend yield. With a currency option, the dividend yield represents the foreign currency's continually compounded risk-free interest rate.
The forward price used for the currency option is a combination of both interest rates in each country. More recent than the Black and Scholes is the Garman and Kohlhagen currency option pricing model. Check out the following books for more information on currency option pricing. As I was writing this article I was thinking of the reasons that may help explain why currencies have higher volatility than equities.
Using end-of-day data, equity indices exhibit about double the amount of volatility than the major currency pairs. Take a look at this:. I calculated both 30 day and day historical volatility and then averaged this across all data sets. Given that currency volatility is, on average, almost half that of an equity index, you could assume that option premiums are relatively half as cheap also. However, FOREX markets are known for their intra day price swings, so perhaps this volatility will drive up option premiums beyond their historical values.
Implied volatility data for currencies is hard to find The spreadsheet uses the Black and Scholes method for European options whereas the currency options priced are American style exercise but I don't imagine a huge difference there. For this example I think it is fine. Still much lower than the current Does it matter that volatility is lower for currencies than other asset types?
It all depends on your trading style. Volatility is factored into the time value of the option. When the level of implied volatility increases this leads to fatter option premiums.
If you're strategy is buying options for directional trades, then higher vols make this more expensive and your profit per trade less. If you love selling naked options or taking on covered calls, then higher option premiums mean more credit to you when you establish the trade. As an option buyer, your only risk is the premium you pay for the option contract. However, when you short an option, your broker allocates a portion of your account as a margin for the position. This is called an "initial margin".
This is called a "maintenance margin". If the margin cannot be maintained due to insufficient funds, the broker will close out the position on behalf of the customer and return any remaining monies back to the client. On top of the currency exposure, margins are also affected by the levels of volatility inherent in the underlying spot currency.
Interest rate movements play a huge role in the movement of currency prices. If, for example, the savings rate of the United States increases while the rates in Australia remain unchanged then money will flow out of Australia and into the US as cash held in the US is now worth more relative to Australia given the current exchange rate.
As the FOREX market moves in response to changing interest rates so does the option premiums whose underlying asset is foreign currency. When pricing foreign currency options the interest rates of both countries need to be considered and entered into an option pricing model - unlike other types of options, such as equity options, futures options etc that only take one input for interest rates to derive a theoretical price.
This interest rate differential between two currencies can be considered as the "cost of carry" for the particular currency spot. In addition to options that have their underlying as foreign currency, option traders may also trade options where the underlying is a currency future.
That is, a futures contract where the underlying is based on the foreign currency. As mentioned earlier, most of the volume traded through currency options takes place in the over the counter market OTC market , whereas options on currency futures are traded on exchanges that can be easily accessed by an online broker.
The Chicago Mercantile Exchange has the most widely available currency futures and currency options in the world. Like all options, when you buy an option your risk is limited to the premium paid for the derivative. Options also carry the "right" to take delivery exercise of the underlying asset if so desired. When you buy a futures contract you are "obligated" to take delivery or cash settle the underlying asset upon expiration. With risk not being limited to a premium as is the case with buying options , a futures contract's risk profile is more aggressive Buying futures contracts also requires the deposit of an "initial margin" upfront that can be much larger than an option premium, which fluctuates on a variety of factors.
The initial margin also earns interest whereas an option premium doesn't - the option premium is paid to the seller, who earns the interest on the amount paid. Biger and Hull's Currency Option Formula. Currency Option Reference Manual. I was curious about why currency options are mainly defined on currency forwards instead of currency spots. Here I have found the clearest explanation in the whole World Wide Web. In the screenshot above from the OptionsTradingWorkbook. Is this version of the xls workbook available for download?
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