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How European Currency Options are Priced

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Like other major financial markets, the forex market also has several active derivatives markets that use forex currency pairs as the underpinning asset.

Derivatives are evaluated using the pricing model that is derived from different market-derived parameters. Within the foreign exchange market Perhaps the largest and oldest of these classes of derivatives are described as FX, forex and currency option. Options traded on the Over the Counter or OTC market, as well as on specific futures and stock exchanges. Options trading on FX is more often accessible to traders at retail via trading sites online.

The currency option market comes with its own over the counter brokers, which are different from the typical FX options broker. The FX Options market produces a significant daily turnover, which makes it one of the most liquid derivative markets worldwide.

What is Currency Options?

In general, currency options are financial agreements that give the right, but not the obligation to the buyer to swap a specific amount of one currency for another at a specified exchange rate known by the term strike. The buyer of a forex option pays the seller a fee or premium in order to acquire this right.

If an option buyer wishes to exercise their currency option, they must do so on or before the date that is the end of contract’s existence. This is also called the expiration date.

When exercising, the stated conversion of the currencies to strike prices must then take place on the settlement date specified by the contract that is typically the date of delivery for the spot on the day when the option’s exercising. For futures contracts involving currency the settlement date will be that of the contract that is underlying.

Options that have an expiration date that is greater than the current exchange rate at the time of the delivery are considered to be in the Money. The ones with a strike cost the same as the prevailing spot exchange rate are referred to that they are at the Money Spot, while those with a strike price set at the prevailing forward rate are said to be in the Money Forward. FX options with an exchange rate worse than the current forward rate are called out of the money.

Because FX options are essentially alternatives to an exchange rate, regular or vanilla currency options typically require the buying of one currency, and the selling of another. The currency that is purchased if the option is granted is known as the call currency, whereas the currency that can be sold is known as”put” currency.

Additionally, currency option contracts generally specify a particular style for their exercise ability. The stated style could include either American Style, which implies that the option can be used at any time prior to its expiration date and European Style, which signifies that the option may only be exercised at the expiration date and at a particular date.

Utilization of Currency Options

The purchase of currency options is to serve as an insurance policy that can be used to safeguard or hedge an existing or anticipated forex position. In this scenario, the option’s premium is paid to guarantee the execution of that forex position at the option’s strike price.

In addition to this, currency options can be sold against an existing foreign currency position to earn additional income and increase the breakeven rate of the position. It is similar to the covered write strategy that is employed by some stock owners. For example traders who are in the long-term GBP/USD currency pair may decide to trade an out of pocket GBP Call/USD Put to restrict profits to the limit of the strike price while increasing their breakevens if the market falls.

Option trading on forex can be combined with options into various strategies that can be used to take strategic positions in the forex market , based on a specific market view, to hedge positions against possible adverse movements and to improve yield.

Additionally, currency options can be used to place bets on the amount of movement anticipated in the underlying market for forex. Since an implied volatility is utilized to price options in the currency market that reflect the magnitude of changes expected in the market, their value tends to rise and decrease based on the magnitude of the market-determined quantity. This allows professional forex option traders to express their views trading implied volatility.

How European Currency Options are priced

Alongside having their price set by demand and supply for exchanges, such as that of the Chicago IMM and PHLX exchanges and PHLX exchanges, currency options may be theoretically priced by using an altered mathematical pricing model that is based on the conventional Black Scholes option pricing model that had been developed to determine the price of stock options.

This model of pricing options in the currency market is known as Garman Kohlhagen model. Garman Kohlhagen model, after two researchers called Garman and Kohlhagen made changes to the Black Scholes model in 1983 to include the different interest rates for each of the two currencies involved in a currency pair.

Traders using the Garman Kohlhagen pricing model for currency options will typically require the input of the following parameters in order to create a hypothetical price for an European Style currency option:

Contact Currency: This is the currency of the currency pair to which gives buyers the option of purchasing to the buyer.
Put Currency – The currency used in the currency pair in which is the choice that grants you the ability to offer to sell it to the buyers.
Strike Price – The rate at which the two currencies in the underlying currency pair will be exchanged in the event that the option is exercised.
Expiration Date – The only day that this option can be exercised since it is a European Style option.
Spot Rate – The current exchange rate for the underlying currency pair.
Spot Delivery Date – The date when the currency will be exchanged if the option is used.
Forward Rate – The current forward rate of exchange for the underlying currency pair for the option’s delivery or settlement date.
Option Delivery Date or Settlement Date the date that the underlying currencies will be exchanged if the option is granted.
Implied Volatility is the market determined level of implied volatility of the underlying currency pair as well as for the stipulated tenor of the options.

The input of the above information into a computer program coded using this Garman Kohlhagen pricing method will result in an amount that is usually expressed in practice as a percentage of base currency value in the marketplace for over the counter. In exchanges such as Chicago IMM Chicago IMM, the quoted price may be expressed as U.S. points per currency amount so that the premium for the option will usually get paid in U.S. Dollars.

To be able to carry out a transaction, the amount of one currency will have be provided for the trader. This will enable the proper computation of the premium, that is the amount expressed in either of the option’s currencies , which the buyer will have to provide to the seller in order to purchase the purchase contract.

Option Intrinsic and Extrinsic Value

European and American Style currency options have two aspects to their worth.

The first part is known as intrinsic value and it is the positive variation, if any, between the strike price of the option and the forward exchange rate prior to the date of the option’s delivery. Options that are deep in the market, with very low levels of implied volatility and are close to expiration tend to be priced out of a majority of intrinsic value.

The second element of the price of an option is called extrinsic value which is remaining value of an option’s current market price. Options that have a large implied volatility a lengthy time remaining until expiration and strike prices that are located at the market tend to have the highest value in extrinsic. The part that is time-based in extrinsic value is commonly referred to as the value of time.

American Style options on the more expensive currency have a slightly greater time value than the essentially identical European Style options, as in the next section, we will go over in greater detail.

American Style Currency Option Pricing and Early Exercise Criteria

American style options are able to take effect at any point before expiration, therefore their pricing requires a modification to this pricing model that has been incorporated into the known as the Binomial Model typically used to price this style of option.

The inputs used to price American Style currency options are identical to those mentioned below as for European Style currency options, however, the pricing of these options must include the potential slight advantage of exercising early to the buyer. In real life, this implies this means that American Style forex options are generally the same price but no cheaper that European Style options.

The variance between the usually more expensive price on the American Style option when compared to an European Style option with otherwise identical parameters is sometimes known as the Ameriplus among traders of currency options.

Since the early use of an American Style option will eliminate the remaining time value in the option — which could be a substantial amount of the value of the option — these options are typically only activated earlier if they’re extremely high-risk money call options for the currency with a higher interest rate.

Furthermore, to justify early exercise in this case, to justify early exercise, the American Style option needs to be in the money in the sense that the positive carry of the basis position until the option’s max delivery date currently exceeds the option’s presently present value in time. If this isn’t the case, it is typically more advantageous to simply sell these American Style options to capture both the time and the intrinsic value, rather than exercise them too early and lose the remaining time value due to.

This is known as the OTC FX Options Market

It is the Over the Counter market for currency options operates among large financial institutions and their customers. Forex options trading typically is done over the telephone or via electronic systems of dealing between customers of the financial institution and the deal desk and market makers employed by an institution of finance. Dealing desk clients might be seeking to hedge corporate exposures when they represent a corporate interest or they might be looking to take risky positions in a currency pair using forex options, if they are working for an investment firm, for example.

Additionally, specialist forex brokers can also provide levels of implied volatility as well as the delta level or strike of interest on currency options that reflect their degree of financial sturdiness for the option. This allows market makers to provide efficient quotations.

Once the implied volatility and delta level or strike price of an transaction has been agreed upon by the broker, the OTC options broker is able to connect the seller and buyer together in the event that credit lines are in place between the potential counterparties to accommodate the magnitude of the transaction.

In general professional market makers that operate within the OTC FX market will typically require that a client coming through their deal desks have an option interest that exceeds $1,000,000 in the notional amount, whereas an OTC FX options broker would typically assist with option transactions with notional values greater than $5,000,000.

Other Ways to Trade Currency Options

If you do not qualify for or prefer not to trade in the OTC market, learning about how to trade currency options via other channels might require some research.

For those that prefer the relative pricing transparency that comes with trading derivatives through an exchange, the majority of exchanges offer liquidity in small amounts of dealing for traders to conduct currency option transactions.

For one forex options are traded on futures exchanges like that of Chicago International Monetary Market or IMM. These are contracts for currency that are based on futures as such, meaning that the actual asset isn’t an actual spot transaction as in the OTC market, but is typically an option on a futures contract. They typically have standard quarterly delivery dates, such as the months of March or June, September or December.

Furthermore, certain stock exchanges can also offer options for currency. The most prominent example is the Philadelphia Stock Exchange or PHLX that offers a set of regular forex option contracts, which have quarterly delivery dates that deliver directly into the spot market, instead of futures contracts.

A relatively recent trading choice that has increased currency option accessibility to the retail market has been the development of forex option brokers online. These brokers usually create markets that offer the traditional European and American type options similar to their counterparts in the OTC market for currency options, or offer exotic currency options like binary options for their customers looking to use them to speculate on the movement of currency pairs.