Currency Options Primer

SHANI SHAMAH has spent over twenty years in the financial market. Her previous book, A Foreign Exchange Primer, is proving to be a great success.

• Disclaimer xi1 Introduction 11.1 The forward foreign exchange market 11.2 The currency options market 11.3 The alternatives to currency options 21.4 The users 21.5 Whose domain? 2PART I MARKET OVERVIEW 32 The Foreign Exchange Market 52.1 Twenty-four-hour global market 52.2 Value terms 52.3 Coffee houses 62.4 Spot and forward market 62.5 Alternative markets 72.6 Currency options 72.7 Concluding remarks 83 A Brief History of the Market 93.1 The barter system 93.2 The introduction of coinage 93.3 The expanding British Empire 103.4 The gold standard 103.5 The Bretton Woods system 113.6 The International Monetary Fund and the World Bank 113.7 The dollar rules OK 123.8 Special drawing rights 123.9 A dollar problem 133.10 The Smithsonian agreement 133.11 The snake 133.12 The dirty float 133.13 The European Monetary System 143.14 The Exchange Rate Mechanism 143.15 The European Currency Unit 153.16 The Maastricht Treaty 153.17 The Treaty of Rome 153.18 Economic reform 163.19 A common monetary policy 163.20 A single currency 163.21 Currency options 183.22 Concluding remarks 204 Market Overview 214.1 Global market 214.2 No physical trading floor 214.3 A “perfect” market 214.4 The main instruments 224.5 Comparisons of options with spot and forwards 234.6 The dollar’s role 244.7 Widely traded currency pairs 244.8 Concluding remarks 255 Major Participants 275.1 Governments 275.2 Banks 275.3 Brokering houses 295.4 International Monetary Market 295.5 Money managers 295.6 Corporations 295.7 Retail clients 295.8 Others 305.9 Speculators 305.10 Trade and financial flows 306 Roles Played 336.1 Market makers 336.2 Price takers 336.3 A number of roles 336.4 A number of roles – options 346.5 Concluding remarks 347 Purposes 357.1 Commercial transactions 357.2 Funding 357.3 Hedging 357.4 Portfolio investment 367.5 Personal 367.6 Market making 367.7 Transaction exposure 367.8 Translation exposure 377.9 Economic exposure 377.10 Concluding remarks 378 Applications of Currency Options 399 Users of Currency Options 419.1 Variety of reasons 419.1.1 Example 1 429.1.2 Example 2 439.1.3 Example 3 439.2 Hedging vs speculation 44Glossary of foreign exchange terms 45PART II CURRENCY OPTIONS – THE ESSENTIALS 4710 Definitions and Terminology 4910.1 Call option 5010.2 Put option 5010.3 Parties and the risks involved 5110.4 Currency option risk/reward perception 5110.5 Currency or dollar call or put option? 5210.6 Strike price and strike selection 5210.7 Exercising options 5310.8 American and European style options 5310.9 In-, at- or out-of-the-money 5510.10 The premium 5710.11 Volatility 5910.12 Break-even 6011 The Currency Option Concept 6112 The Currency Options Market 6312.1 Exchange vs over-the-counter 6312.2 Standardised Options 6512.3 Customised options 6612.4 Features of the listed market 6712.5 Comparisons 6912.6 Where is the market? 6912.7 Concluding remarks 6913 Option Pricing Theories 7113.1 Basic properties 7113.2 Theoretical valuation 7213.3 Black-Scholes model 7313.4 Examples of other models 7413.5 Pricing without a computer model 7613.6 Educated guess 7613.7 The price of an option 7613.8 Option premium profile 7813.9 Time value and intrinsic value 7813.10 Time to expiry 7913.11 Volatility 7913.12 Strike price and forward rates 8213.13 Interest rates 8213.14 American vs European 8313.15 Concluding remarks 8414 The Greeks 8514.1 Delta 8514.2 Gamma 8814.3 Theta 9014.4 Vega 9214.5 Rho 9214.6 Beta and omega 9315 Payoff and Profit/Loss Diagrams 9515.1 Payoff diagram 9515.2 Profit diagram 9515.3 The option writer 9715.4 Put option 9715.5 Put option writer 9815.6 Basic option positions 9815.7 Graph addition 10015.8 Profit/loss profiles for ten popular option strategies 10115.9 Concluding remarks 10216 Basic Properties of Options 10516.1 Option values 10516.2 Put/call parity concept 10616.3 Synthetic positions 10817 Risk Reversals 11117.1 Understanding risk reversals 11117.2 Implications for traders 11217.3 Implications for hedgers 11317.4 Concluding remarks 11418 Market Conventions 11518.1 Option price 11518.2 What rate to use? 11618.3 Live price 11618.4 Pricing terms 11718.5 Premium conversions 11718.6 Settlement 11718.7 How is an option exercised? 11818.8 Risks 11818.9 Concluding remarks 119Basic option glossary 121PART III CURRENCY OPTION PRODUCTS 12519 Vanilla Options 12719.1 Long options 12719.2 Short options 12719.3 Straddle 12819.4 Strangle 12919.5 Cylinder 13019.6 Collar 13119.7 Participating forward 13119.8 Ratio forward 13219.9 Added extras to vanilla options 13320 Common Option Strategies 13520.1 Directional options 13720.2 Precision options 13920.3 Locked trade options 14421 Exotic Options 14521.1 Barriers 14521.2 Average rates 14821.3 Lookback and ladder 14921.4 Chooser 15221.5 Digital (binary) 15321.6 Baskets 15421.7 Compound 15621.8 Variable notional 15721.9 Multi-factor 15822 Structured Currency Options 15922.1 Trigger forward 15922.2 Double trigger forward 16022.3 At maturity trigger forward 16122.4 Forward extra 16122.5 Weekly reset forward 16222.6 Range binary 16322.7 Contingent premium 16322.8 Wall 16422.9 Corridor 16523 Case Studies 16723.1 Hedging 16723.2 Trading 16923.3 Investment 17023.4 Bid to offer exposure 17123.5 Concluding remarks 17324 Option Hedge Matrix 175Exotic currency option glossary 18725 Concluding Remarks 193Index 195