Professional Documents
Culture Documents
Michael Taylor
FinPricing
Currency Option
Summary
Currency Option or FX Option Introduction
The Use of Currency Option
Forex Market Convention
Currency Option Payoffs
Valuation
Practical Guide
A Real World Example
Currency Option
Payoffs
• The payoff of a European call option
𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑁𝑏 ∗ 𝑚𝑎𝑥(𝑋 − 𝐾, 0)
where
Nb the notional of the base currency
X the spot FX rate
K the strike.
• The payoff diagram of a European call option
4
2
Payoff
0
0 1 2 3 4 5
-1
-2
FX Rate
Currency Option
Payoffs (Cont)
• The payoff of a European put option
𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑁𝑏 ∗ 𝑚𝑎𝑥(𝐾 − 𝑋, 0)
where
Nb the notional of the base currency
X the spot FX rate
K the strike.
• The payoff diagram of a European put option
5
4
3
Payoff
2
1
0
-1 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
-2
FX Rate
Currency Option
Valuation
European FX Option
• The present value of a European call option is given by
𝑃𝑉 𝑡 = 𝑋0 𝑒−𝑟𝑞 𝑇𝑑 −𝑇𝑠
Φ 𝑑1 − 𝐾𝑒−𝑟𝑏 𝑇𝑑 −𝑇𝑠 Φ(𝑑2 )
where
𝑑1,2 = 𝑙𝑛 𝑋0 𝐾 + 𝑟𝑏 𝑇𝑑 − 𝑇𝑠 − 𝑟𝑞 (𝑇𝑑 − 𝑇𝑠 ) ± 𝜎2 (𝑇𝑒 − 𝑡) 𝜎 𝑇𝑒 − 𝑡
t the valuation date
𝑋0 the spot FX rate quoted as base/quote
K the strike using the same quotation as the spot rate
𝑇𝑠 the spot date (several days after valuation date)
𝑇𝑑 the option delivery date
Currency Option
Valuation (Cont)
𝑇𝑒 the option expiry date
𝑟𝑏 the base currency interest rate for period (𝑇𝑠 , 𝑇𝑑 )
𝑟𝑞 the quote currency interest rate for period (𝑇𝑠 , 𝑇𝑑 )
𝜎 the volatility corresponding to K and (𝑇𝑒 -t)
Φ the cumulative standard normal distribution function
• The present value of a European call option is given by
Valuation (Cont)
American FX Option
• FinPricing is using the Odd-Even Cox Ross Binomial model to compute
prices and risk sensitivities for American-style FX OTC options.
• The Odd-Even Binomial model is an extension of the Cox Ross Binomial
model. Compared to Cox Ross Binomial model, the Odd-Even Binomial
model provides better price accuracy. It was implemented by creating two
tress, one with even number n of iterations and another with n+1 number
of iterations, then taking the average of the two results. This method also
helps to reduce the number of oscillations that can be observed with
traditional Binomial models, where the option value depends quite heavily
on the number of periods.
Currency Option
Practical Guide
• Please note the time differences in the formulas above, which is an
important factor in order to apply the Black formula to the FX
market. Usually the delivery date is different from the expiry date.
• First, you need to construct interest rate zero curves for both base
and quote currencies.
• The curve construction in FX world is different from the one in
interest rate world.
• Second, you need to construct an arbitrage-free volatility surface.
FinPricing is using Vanna Volga model to construct FX volatility
surface.
• After that, you can use the formulas to calculate the price and risk
sensitivities.
Currency Option