Back to: ECONOMIC ANALYSIS & MONETARY POLICY
Currency Option Definition
A currency option is a type of contract that grants the buyer the right to purchase or sell an amount of a specific currency at a fixed exchange rate and on a particular date. A currency option only confers the right and not an obligation to the buyer, that means a buyer is not under any compulsion to buy or sell a given amount of the currency. However, one benefit of currency option to the holder is that it allows the holder to benefit from the movements of the currency and also reduce the risk that the option holder is exposed to.
A Little More on What What is a Currency Option
There are two major types of currency option, the American currency option and the European currency option. The American currency option allows the holder to buy or sell an amount of a given currency on any date or at the fixed date while the European option allows that sale or purchase to be made at a fixed future date. The standard Currency option is however more straightforward, it is otherwise called vanilla. Currency option is not restricted to a particular set of individuals, rather, anyone can be a currency option holder depending on the movement of prices.
Features of the Currency Options
The major features of a currency option include the following;
- Currency option allows the holder to enjoy the benefits of movements of currency pairs and also limit the risks the holder faces.
- Currency option aids flexibility in investment, it is a unique trading tool that traders use when negotiating.
- It gives the buyer the right but not an obligation to buy and sell an amount of a specific currency at a fixed future date.
- A currency option has a fixed future date, otherwise called its expiration date.
- Premium and strike (exercise) price are present in currency options.
In exercising currency option, valuation is an important concept and this entails two core components which are the intrinsic and temporary value of the asset. The intrinsic value of an asset is often referred to as the price of the less which is below the strike of the option. The temporary value however is the amount at which the option value exceeds the intrinsic value of the asset. It is temporary because this difference is not static, it is often short-lived.
Furthermore, in currency option, it is vital to know that the differences in the interest rates of the currency pair plays out in how the negotiation or price would turn out. The timing is another crucial factor to consider.
References for Currency Option
Academic Research for Currency Option
Foreign currency option values, Garman, M. B., & Kohlhagen, S. W. (1983). Journal of international Money and Finance, 2(3), 231-237. This research has been carried out to discuss the values of foreign currency options. One of the latest market innovations is foreign exchange (FX) options. The standard BS option-pricing model (Black-Scholes) does not apply to foreign exchange options very well because there is involvement of multiple interest rates in ways different from the BS assumptions. This article presents alternative assumptions which lead to valuation formulas for FX options. These formulas are strongly connected to Black’s commodity pricing model when there are forward prices given and also to the PDSM (Proportional Dividend Model of Samuelson & Merton when there are spot prices given.
Regime switching in foreign exchange rates:: Evidence from currency option prices, Bollen, N. P., Gray, S. F., & Whaley, R. E. (2000). Journal of Econometrics, 94(1-2), 239-276. This article evaluates the regime-switching models to consider the dynamics of Foreign Exchange (FX) rates. The authors check whether the models are able to fit data of FX rate in the sample and calculate the variance from it. A Regime-Switching Model (RSM) with independent shifts in variance and mean show a closer fit and variance forecasts more accurate as compared to other models. The authors apply exchange-traded options of currency to estimate whether market prices provide regime-switching information. The findings are that the observed option prices highly differ from their theoretical levels estimated by an RSM of option valuation. These prices do not completely reflect regime-switching information.
Currency option bonds, puts and calls on spot exchange and the hedging of contingent foreign earnings, Feiger, G., & Jacquillat, B. (1979). The Journal of Finance, 34(5), 1129-1139. This article is about 2 types of securities which can be traded in global capital markets. The first is the currency option bonds. Their holders can freely nominate the currency in which principal and coupons are paid as per explicit exchange rates determined in the actual bond contract. In the European market, these instruments are considered as a well-established phenomenon. The second is calls and puts on the spot exchange. These options are similar to ‘calls and puts’ on the common stock, e.g. a USD per DM call will entitle the holder to exchange a certain number of US dollars for a certain number of DM during the course of contract at any date.
Uncertain currency model and currency option pricing, Liu, Y., Chen, X., & Ralescu, D. A. (2015). International Journal of Intelligent Systems, 30(1), 40-51. This paper explains the Uncertainty Currency Model (UCM) and currency option pricing. To cope with the noise process, there is a new tool used on the basis of uncertainty theory, it is called Liu process. This study overviews the Foreign Exchange (FX) rate as an uncertain process which the uncertain differential equations, formulated by the Liu process, describe. The authors discuss the problems of uncertain currency option. In addition, they derive American and European pricing formulas for currency option for the presented model of uncertain currency and go through some mathematical properties. Finally, they elaborate it with the help of numerical examples.
Currency option pricing with stochastic domestic and foreign interest rates, Hilliard, J. E., Madura, J., & Tucker, A. L. (1991). Journal of Financial and Quantitative Analysis, 26(2), 139-151. In this paper, the authors propose a currency option pricing model with stochastic rates of interest when there holds the interest rate parity assuming that foreign and domestic bond prices depict local variances depending on time only. The authors show how one can simply derive the available currency option models from a framework. Empirical tests using transaction option data show that a specifically simple stochastic rate model is more accurate uniformly as compared to a constant rate model for all maturities and boundaries tested.
The valuation of currency options, Biger, N., & Hull, J. (1983). Financial Management, 24-28. This paper describes 2 alternative methods to the valuation of calls and puts options on foreign currency. An interesting thing to note is that, in the valuation formulas, the forward exchange rate has a vital role. The authors provide examples for the use of options to hedge risks of foreign exchange.
Realignment risk and currency option pricing in target zones, Dumas, B., Jennergren, L. P., & Näslund, B. (1995). European Economic Review, 39(8), 1523-1544. This article is an extension of the Krugman Target Zone (KTZ) Model. It adds a realignment mechanism. The authors discuss the different features of this realignment mechanism. Both the processes govern the exchange rate movement, i.e. a Wiener Process (WP) on fundamental and a Poisson Jump Process (PJP) with endogenous realignment size. This mechanism is such that in fundamental, no jump is required to incorporate the jump in the exchange rate (except a situation in which a speculative attack takes place). The authors construct a currency options valuation that is risk-neutral. Finally, the numerical results illustrate some features of option values in realignment risk.
TESTS OF THE BLACK‐SCHOLES AND CONSTANT ELASTICITY OF VARIANCE CURRENCY CALL OPTION VALUATION MODELS, Tucker, A. L., Peterson, D. R., & Scott, E. (1988). Journal of Financial Research, 11(3), 201-214. This paper tests an adaptation of the CR/EM call option valuation (Cox-Ross/Emanuel-MacBeth) Model for processes of variance diffusion constant elasticity against an adaptation of the BS valuation model of the call option (Black-Scholes) for the call currency options pricing. The authors use synchronized transactions data provided by the Philadelphia Exchange. The highest likelihood estimation procedure shows an important association between exchange rate levels and currency return variances. The variance model constant elasticity demonstrates considerably superior pricing accuracy for anticipated intervals of 3 or less trading days.
Empirical tests of the efficiency of the currency option market, Tucker, A. L. (1985). Journal of Financial Research, 8(4), 275-285. This research conducts tests of a rational boundary of the currency options market efficiency and a hedge. These tests use data of transactions and account for the impacts of currency and ask spreads/option bid, synchronization of exchange rates, execution lags, currency options, transaction costs and market depth. Currency options show continuous dividends. The data set and options’ nature makes the instant exercise lower bound test which is the market efficiency purest test, today. The findings are that when the authors conduct these tests, they are not able to earn riskless arbitrage or abnormal economic profits.
A numerical approach to American currency option valuation, Choi, S., & Marcozzi, M. D. (2001). The Journal of Derivatives, 9(2), 19-29. The family of HJM (Heath-Jarrow-Morton) presents models widely used in the economic world. However, its implementation comes across computational issues as the state variables rise in number. This paper presents a numerical technique on the basis of estimating the option value with the help of radial basis functions offering significant efficiency improvement. The authors explain how to apply it to the style of Heath-Jarrow-Morton (HJM) currency options. A great benefit of this technique is that the nature of estimating functions is analytic. This is to directly obtain the Greek letter risk exposure using calculus instead of requiring multiple runs by a pricing lattice to estimate them.
Biases in option prices: Evidence from the foreign currency option market, Adams, P. D., & Wyatt, S. B. (1987). Journal of Banking & Finance, 11(4), 549-562. This article evaluates a European option pricing call model over a data set that does not face the early exercise issues pledged old literature of call options on common stock. The authors particularly evaluate an American call prices data set on spot foreign exchange that plausibly applies the modified version of GKG (Garman-Kohlhagen & Grabbe) European call option model. The authors adjust the risk of interest rates. The findings are that the model is almost unbiased in the foreign currency options valuation. Thus, interest rate differential risk (similar to risky dividends) is a vital element in the foreign currency options valuation.