Foreign exchange options
For example, for an FX forward against USD, the standard date calculation for spot settlement is two business days in the non-dollar currency, and then the first good business day that is common to the currency and New York.
For an FX option, cash settlement is made in the same manner, with the settlement calculation using the option expiry date as the start of the calculation. The settlement convention affects discounting cash flows and must be considered in the valuation. Regarding the possible input formats, the users can specify the conventions for the two currencies of the FX rate manually, in a combined or separate manner.
For the former, two elements can be taken in as maturity descriptor and holiday convention that are shared for both currencies. For the latter, five elements can be taken in as one set of maturity descriptor and holiday convention for the currency one, another set of similar inputs for the currency two and an additional input of holiday convention.
This corresponds to the most generic specification of the settlement convention that can be used for cross rate trades, e. These and other assumptions allow us to utilize generic option models, such as Black-Scholes , in the valuation of FX options. A wide 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—Kohlhagen , risk 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 risk numbers with a counterparty e.
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This page was last edited on 23 March , at Options offset unpredictable FX inflows. Marketers of options often claim that currency options are ideal instruments for hedging uncertain foreign currency cash flows, because the option gives the corporation the right to purchase or sell the foreign currency cash flow if a company wins an offshore contract say, but no obligation to do so if their bid is rejected. It has a surface logic: The drawback of this approach, however, is that most of the time you have claims contingent on two different events.
Winning or losing the contract depends on your competition and a host of "real" factors, while gains or losses on the option are dependent on movements of the currency and its variability.
A firm buying an option to hedge the foreign currency in a tender bid is paying for currency volatility and in fact taking a position in the options market that will not be extinguished by the success or otherwise of its bid. In other words, whether or not the bid is accepted, the option will be exercised if it is in the money at expiration and not otherwise, and the options price will rise and fall as the probability of exercise changes.
In buying the "hedge," the bidder is actually purchasing a risky security whose value will continue to fluctuate even after the outcome of the bid is known. Are Currency Options Ever Useful? Yes, in certain well-defined situations, but these are situations that, I believe, few companies seem to grasp. There is one kind of foreign currency cash flow for which the conventional currency option is perfectly suited: Then both the natural exposure and the hedging instrument have payoffs that are exchange rate contingent and a currency option is exactly the right kind of hedge.
By way of illustration, consider an American firm that sells in Germany and issues a price list in German marks. If the mark falls against the dollar, the Germans will buy your doodads, but of course you will get less dollars per doodad. If the mark rises, the clever Germans will instead buy from your distributor in New Jersey whose price list they also have. Your dollar revenues are constant if the mark rises but fall if the mark drops.
Perhaps you were dumb to fix prices in both currencies; what you have effectively done is to give away a currency option. This asymmetric currency risk can be neatly hedged with a put option on DM. A variation on the above could be one where the company's profitability depends in some asymmetric fashion on a currency's value, but in a more complex way than that described by conventional options.
An example might be where competitive analysis demonstrates that should a particular foreign currency fall to a certain level, as measured by the average spot rate over three months, then producers in that country would gear up for production and would take away market share or force margins down.
Anticipation of such an event could call for purchasing so-called Asian options, where the payoff depends not on the exchange rate in effect on the day of expiration, but on an average of rates over some period.
There are some other situations that could justify the use of currency options. And one of these is averting the costs of financial distress. Hedging can under some circumstances reduce the cost of debt: Where fluctuations in the firm's value can be directly attributed to exchange rate movements, the firm may be best off buying a out-of-the-money currency options.
In such a case it would be buying insurance only against the extreme exchange rate that would put the firm into bankruptcy. Where does that leave us? The general rule about hedging tools is that specific kinds of hedging tools are suited to specific kinds of currency exposure. Whatever happens to your "natural" positions, such as a foreign currency asset, you want a hedge whose value changes in precisely the opposite fashion.
Thus forwards are okay for many hedging purposes, because the firms' natural position tends to gain or lose one-for-one with the exchange rate. Even this is often untrue. But the kind of exposure for which foreign exchange options are the perfect hedge are much rarer, because contracts are not won or lost solely because of an exchange rate change. A currency option is the perfect hedge only for the kind of exposure that results from the firm itself having granted an implicit currency option to another party.
Usually, currency options offer an imperfect hedge, while plain, boring old forward contracts can do the job more effectively. Frequently corporate treasurers use options to get the best of both worlds: