FOREIGN EXCHANGE OPTION
In finance, a foreign-exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the owner the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158.3 trillion in 2005
Call option – the right to buy an asset at a fixed date and price.
Put option – the right to sell an asset a fixed date and price.
Foreign exchange option – the right to sell money in one currency and buy money in another currency at a fixed time and relative price.
Strike price – the asset price at which the investor can exercise an option.
Spot price – the price of the asset at the time of the trade.
Forward price – the price of the asset for delivery at a future time.
The difference between FX options and traditional options is that in the latter case the trade is to give an amount of money and receive the right to buy or sell a commodity, stock or other non-money asset. In FX options, the asset in question is also money, denominated in another currency.
CALL OPTION
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option.[1] The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option purchases it in the hope that the price of the underlying instrument will rise in the future. The seller of the option either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples).
Buying a call
An investor typically 'buys a call' when he expects the price of the underlying instrument will go above the call's 'strike price,' hopefully significantly so, before the call expires. The investor pays a non-refundable premium for the legal right to exercise the call at the strike price, meaning he can purchase the underlying instrument at the strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the profit. Of course, the investor can also hold onto the underlying instrument, if he feels it will continue to climb even higher.
Payoff from buying a call.
Writing a Call
An investor typically 'writes a call' when he expects the price of the underlying instrument to stay below the call's strike price. The writer (seller) receives the premium up front as his or her profit. However, if the call buyer decides to exercise his option to buy, then the writer has the obligation to sell the underlying instrument at the strike price. Often the writer of the call does not actually own the underlying instrument, and must purchase it on the open market in order to be able to sell it to the buyer of the call. The seller of the call will lose the difference between his or her purchase price of the underlying instrument and the strike price. This risk can be huge if the underlying instrument skyrockets unexpectedly in price.
Payoff from writing a call.
PUT OPTION
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity. One party, the buyer of the put, has the right, but not an obligation, to sell the asset at the strike price by the future date, while the other party, the seller, has the obligation to buy the asset at the strike price if the buyer exercises the option.
An American option can be exercised at any time before or equal to T; a European option can be exercised only at time T; a Bermudan option can be exercised only on specific dates listed in the terms of the contract. If the option is not exercised by maturity, it expires worthless.
Buying a put
A Buyer thinks the price of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike price.
Payoff from buying a put.
Writing a put
The writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium.
Payoff from writing a put.
Moneyness
Moneyness is a term describing the relationship between the strike price of an option and the current trading price of its underlying security. Where settlement is financial, the difference between the strike price and the spot price will determine the value, or "moneyness", of the contract.
In options trading, terms such as in-the-money, at-the-money and out-of-the-money describe the moneyness of options.
A call option is in-the-money if the strike price is below the market price of the underlying stock. (SP<MP)A put option is in-the-money if the strike price is above the market price of the underlying stock(SP>MP)
A call or put option is at-the-money if the stock price and the exercise price are the same (or close).(SP=MP)
A call option is out-of-the-money if the strike price is above the market price of the underlying stock(SP>MP). A put option is out-of-the-money if the strike price is below the market price of the underlying stock(SP<MP).
CURRENCY SWAPS
A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap.
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.
There are three different ways in which currency swaps can exchange loans:
- The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.
- Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.
- Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross currency swap
Uses
Currency swaps have two main uses:
- To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan)
- To hedge against (reduce exposure to) exchange rate fluctuations.
