Kirt C. Butler, Multinational Finance, 4e, ©2008, John Wiley & Sons LTD

Kirt C.
Butler, Multinational Finance, 4e, 2008, John Wiley & Sons Ltd
Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Forward versus option payoffs Currency option contracts Option payoff profiles Put-call parity at expiration
Chapter 6 Currency Options and Options Markets

Learning objectives Option payoffs
Payoff profiles and profit/loss diagrams Option value determinants
A forward obligation
A 1 million obligation due in four months
Currency exposure Underlying transaction v$/
Hedging with options

Combinations of options & with underlying positions
6-1 Butler / Multinational Finance Chapter 6 Currency Options and Options Markets
Exchange rate volatility

Implied volatility
Butler / Multinational Finance Chapter 6 Currency Options and Options Markets
-1,000,000
s$/
6-2
Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation
Forward versus option payoffs Currency option contracts Option payoff profiles Put-call parity at expiration
A forward hedge
Buy 1 million in the forward market at the forward price F1$/ = $1.60/
Exposure of forward contract Long pound forward +1,000,000 -$1,600,000 s$/
An option hedge
A currency option is like one-half of a forward contract
- the option holder gains if pound sterling rises - the option holder does not lose if pound sterling falls
v$/ v$/ s$/
Long pound call (option to buy pound sterling)
CME pound Dec 1600 call (American) Type of option: a call option to buy pounds
Underlying asset: CME December pound sterling futures contract Contract size: 62,500 Expiration date: 3rd week of December Exercise price: $1.60/ Rule for exercise: an American option exercisable anytime until expiration
Currency option quotations

British pound (CME)
62,500 pounds; cents per pound Strike Price 1580 1590 1600 1610 1620
Butler / Multinational Finance
Calls-Settle Puts-Settle Oct Nov Dec Oct Nov Dec 8.99 . . . . 10.45 7.00 7.77 8.48 8.49 9.26 9.97 7.49 8.27 8.98 8.00 8.78 9.49 8.00 8.78 9.49 7.54 8.32 9.04 8.54 9.31 10.02 7.10 7.88 8.60 9.09 . . . . 10.57 (for i$ = i)
6-6 Chapter 6 Currency Options and Options Markets
Note: S0$/ = Ft$/ = $1.60/
Kirt C. Butler, Multinational Finance, 4e, 2008, John Wiley & Sons Ltd
Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Forward versus option payoffs Currency option contracts Option payoff profiles Put-call parity at expiration Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Forward versus option payoffs Currency option contracts Option payoff profiles Put-call parity at expiration
Payoff profile of a pound call at expiration

CallT$/ In-the-money
+$0.24/
CallT$/
Profit (loss) on a long call at expiration
+$0.08/
Out-of-the-money
-$0.08/
K$/
$1.60/ $1.76/
$1.76/ -$5,000 -$100,000 $125,000 -$20,000
ST$/
$1.92/
$1.92/ -$5,000 -$100,000 $150,000 +$45,000
$0.16/
K$/
$1.60/ $1.76/
$/ T
6-7
FX rate at expiration $1.60/ (Premium)*(contract size) -$5,000 (Exercise price)*(contract size) $0 (Spot sale)*(contract size) $0 Net profit -$5,000
6-8
Payoff profile of a call option at expiration

Long call
CallT$/
Payoff profile of a call option at expiration

PutT$/ -PutT$/
Short call
-CallT$/
Long put
KT$/ ST$/ ST$/
Short put
KT$/ ST$/
KT$/
ST$/
KT$/
Out-ofthemoney
In-themoney
Out-ofthemoney
In-themoney
6-9
In-themoney
Out-of-themoney
In-themoney
Out-of-themoney
6-10
Puts and calls

Call option to buy pounds at KT$/
CallT$/
Forwards, puts, and calls

An option to sell dollars at KT/$
PutT/$
A combination of a long call and a short put at the same exercise price and with the same expiration date results in a long forward position at that forward price Long call
CallT
$/
Short put
Long forward
FT$/
=
ST$/ ST/$
ST$/
PutT$/ ST$/
ST$/
6-11 Butler / Multinational Finance Chapter 6 Currency Options and Options Markets Butler / Multinational Finance Chapter 6 Currency Options and Options Markets
6-12
Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Forward versus option payoffs Currency option contracts Option payoff profiles Put-call parity at expiration Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Option value = Intrinsic value + Time value Time value and volatility
Put-call parity at expiration: CallTd/f

CallT$/
Option value = (Intrinsic value) + (Time value)
PutTd/f
Kd/f
FTd/f
KT$/
- Intrinsic value = value if exercised immediately - Time value = additional value prior to exercise
-PutT$/
ST$/
+
FT$/
ST$/
Long call
Short put
Exercise price
KT$/
ST$/
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 in currency d - Riskless rate of interest if in currency f - Volatility in the underlying exchange rate
6-13
=
Long forward
ST
$/
- Time to expiration
6-14
Option value = Intrinsic value + Time value Time value and volatility
Call value
Time value and volatility
Currency call option value
Time value and volatility
Call option value
High volatility Low volatility
Time value Intrinsic value
Time value Intrinsic value
Exchange rate
Spot rate
6-15 Butler / Multinational Finance
Exchange rate distribution

6-16
A short straddle
The interaction of time and volatility

If instantaneous changes are a random walk, then T-period variance is T times the one-period variance T2 = T 2 where 2 = 1-period variance T2 = T-period variance Estimation of exchange rate volatility - Historical volatility - Implied volatility
Profit (loss) on a short straddle
Short straddle
Short put
Short call
Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Infrequent compounding More frequent compounding The binomial and Black-Scholes models Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Infrequent compounding More frequent compounding The binomial and Black-Scholes models
Advanced: Pricing currency options

Suppose St = A$2.40/ bifurcates by a continuously compounded 4 percent per period for 4 periods
A$/
4 percent for 4 periods
+16% 2.816 +8% 2.600 0% 2.400 -8% 2.215 -16% 2.045
+12% 2.706 +8% 2.600
Four (4) successive bifurcations result in price paths Value after 1 period is P1 = P0 e0.04 (A$2.40/)e-0.04 = A$2.306/ (A$2.40/)e+0.04 = A$2.498/ each with 50 percent probability
24
= 16
+4% 2.498
+4% 2.498 -4% 2.306 -12% 2.129
2.400
0% 2.400 -8% 2.215
-4% 2.306
6-20
Infrequent compounding More frequent compounding The binomial and Black-Scholes models
24 = 16 possible price paths
1 1 4 3
End-of-period distribution for n = 4

0.40
1 1 1 1 1 1
n = 2n =
0.30
2 3
6
0.20
4
0.10
1
1 2 2 4 3 8 4 16
0.00
6-21
2.045
2.215
2.400
2.600
2.816
6-22
More frequent compounding

Suppose we apply this binomial model with 1% per period for 16 periods This results in 216 = 65,536 price paths and (n+1) = 17 possible prices
1 percent for 16 periods

+3% 2.473 +2% 2.448 +1% 2.424
+5% +4% 2.498 +2% 2.448 0% 2.400 -2% 2.352 -4% 2.306

6-24
+1% 2.424 -1% 2.376 -3% 2.329
2.400
0% 2.400 -2% 2.352
-1% 2.376
Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Infrequent compounding More frequent compounding The binomial and Black-Scholes models Option payoffs Option value determinants Combinations of options Advanced: Currency option valuation Infrequent compounding More frequent compounding The binomial and Black-Scholes models
End-of-period distribution for n = 16

0.20 0.15 0.10 0.05 0.00
Equivalence of the Binomial & Black-Scholes option pricing models

As the binomial process generating up and down movements bifurcates over shorter and shorter intervals
- the binomial distribution approaches the normal distribution - and binomial option pricing models approximate continuous-time option pricing models (e.g. Black-Scholes)
6-25 Butler / Multinational Finance Chapter 6 Currency Options and Options Markets 6-26
2.045
2.129
2.215
2.306
2.400
2.498
2.600
2.706
2.816

Kirt C. Butler, Multinational Finance, 4e, ©2008, John Wiley & Sons LTD

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Kirt C. Butler, Multinational Finance, 4e, ©2008, John Wiley & Sons LTD

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Kirt C.

Chapter 6 Currency Options and Options Markets

Hedging with options

Exchange rate volatility

v$/ v$/ s$/

Long pound call (option to buy pound sterling)

Currency option quotations

Note: S0$/ = Ft$/ = $1.60/

Payoff profile of a pound call at expiration

Profit (loss) on a long call at expiration

Butler / Multinational Finance

Chapter 6 Currency Options and Options Markets

Chapter 6 Currency Options and Options Markets

Payoff profile of a call option at expiration

Payoff profile of a call option at expiration

Chapter 6 Currency Options and Options Markets

Chapter 6 Currency Options and Options Markets

Puts and calls

Forwards, puts, and calls

Put-call parity at expiration: CallTd/f

Option value = (Intrinsic value) + (Time value)

Chapter 6 Currency Options and Options Markets

Time value and volatility

Currency call option value

Time value and volatility

Call option value

High volatility Low volatility

Time value Intrinsic value

Time value Intrinsic value

6-15 Butler / Multinational Finance

Exchange rate distribution

The interaction of time and volatility

Profit (loss) on a short straddle

Advanced: Pricing currency options

4 percent for 4 periods

+16% 2.816 +8% 2.600 0% 2.400 -8% 2.215 -16% 2.045

+12% 2.706 +8% 2.600

+4% 2.498 -4% 2.306 -12% 2.129

0% 2.400 -8% 2.215

24 = 16 possible price paths

End-of-period distribution for n = 4

Chapter 6 Currency Options and Options Markets

Chapter 6 Currency Options and Options Markets

More frequent compounding

1 percent for 16 periods

+1% 2.424 -1% 2.376 -3% 2.329

0% 2.400 -2% 2.352

End-of-period distribution for n = 16

Equivalence of the Binomial & Black-Scholes option pricing models

Butler / Multinational Finance

Chapter 6 Currency Options and Options Markets

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