Part 3: Currency derivatives: options
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In finance, a foreign exchange option commonly shortened to just FX option or currency option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The foreign exchange options market is the deepest, largest and most liquid market for options of any eur call usd put option. Most trading is over the counter OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities ExchangePhiladelphia Stock Exchangeor the Chicago Mercantile Exchange for options on futures contracts.
In this case the pre-agreed exchange rateor strike priceis 2. If the rate is lower than 2. The difference between FX options and traditional options is that in the latter case the trade is to give an eur call usd put option of money and receive the right to buy or sell a commodity, stock or other non-money asset. In FX options, the asset in question is also money, denominated in another currency.
For example, a call option on oil allows the investor to buy oil at a given price and date. The investor on the other side of eur call usd put option trade is in effect selling a put option on the currency. To eliminate residual risk, match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don't offset. Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwardsand uncertain foreign cash flows with options.
This uncertainty exposes the firm to FX risk. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk. If the cash flow is uncertain, a forward FX contract exposes the firm to FX risk in the opposite direction, in the case that the expected USD cash is not received, typically making an option a better choice.
As in the Black—Scholes model for stock options and the Black model for certain interest rate optionsthe value of a European option on an FX rate is typically calculated by assuming that the rate follows a log-normal process. In Garman and Kohlhagen extended the Black—Scholes model to cope with the presence of two interest rates one for each currency.
The results are also in the same units and to be meaningful need to be converted into one of the currencies. A eur call usd put option range of techniques are in use for calculating the options risk exposure, or Greeks as for example the Vanna-Volga method.
Although the option prices produced by every model agree with Garman—Kohlhagenrisk numbers can vary significantly depending on the assumptions used for the properties of spot price movements, volatility surface and interest rate curves.
After Garman—Kohlhagen, the most common models are SABR and local volatility [ citation needed ]although when agreeing eur call usd put option numbers with a counterparty e.
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