19 March Practice Pricing Foreign Exchange Option Contracts March 19, 2018By FX Initiative FX Derivative Speculator, FX Spot & Derivatives , At the money, Call, Continuing Professional Education, Example, Garman-Kohlhagen, Hedging, In the money, Managmement, Option Contracts, Out of the money, Put, Risk, Time Value, Volatility, CPE, Foreign Exchange, Intrinsic Value, Strike 0 Option contracts are financial contracts that give the buyer the right, not the obligation, to buy or sell a quantity of a particular currency at a specific exchange rate, called the strike rate, on or before a pre-arranged date. A call option is the right to buy a particular currency, and a put option is the right to sell a particular currency. An option is a right, not an obligation, so it will be exercised only when it is favorable to do so. An option is comprised of two value drivers, (1) intrinsic value, which is the difference between the strike rate on the contract and the then prevailing spot rate in the market, and (2) time value, which is any excess value beyond intrinsic value related to time to maturity. A purchased option begins its life as an asset in the amount of the option premium paid to the counterparty at inception, typically purely time value, and will expire with a either a positive intrinsic value or zero fair value. When intrinsic value is positive, it is referred to as “in the money” since the strike rate is more favorable than the spot rate, and when intrinsic value is zero is referred to as “at the money” if the strike rate is equal to the spot rate or “out of the money” if the strike rate is less favorable than the spot rate. Options, when hedging, secure the value of an underlying position, providing 100% protection against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves, which may justify the premium paid. Options tend to be used most frequently for longer dated exposures such as forecasted transactions, since the greater the timeframe, the greater the potential for the market to move materially, which creates greater potential to participate in favorable market movements. Options are also attractive for scenarios where there is uncertainty the exposure will materialize, such as a bid to award contract or a forecasted acquisition, since an option is a right, not an obligation. Options provide a high degree of certainty and the greatest degree of flexibility, but are employed less frequently in practice when hedging due to the premium paid up front. In order to price an option contract, a number of option pricing models can be used in the marketplace, but currency options are priced most often using the Garman-Kohlhagen option-pricing model. The Garman-Kohlhagen option-pricing model is a complex equation that takes into account the following six variables: The spot foreign exchange rate The interest rate on the base currency The interest rate on the terms currency The strike rate of the option The time to expiration The volatility of the currency pair. To illustrate the concept of an option contract, this Foreign Exchange Derivative Speculator can model the economic and accounting aspects of both a put and a call option. The first step is to select a long position, which represents a call option to buy the currency, or a short position, which represents a put option to sell the currency. The next step is to enter the parameters of the trade, which includes specifying the currency pair, spot rate, trade date, expiration date, notional amount, and currency quoting convention. In step 2, select an option contract as the foreign exchange derivative instrument, and enter the pricing variables outlined above, which include the domestic and foreign interest rates, the strike rate (which is the exchange rate that the option contract can be exercised at), and the volatility of the currency pair. You can change any of the option variables to instantly see the impact on the premium, or cost, of the option contract. For example, adjusting the strike rate lower or higher will increase or decrease the premium of the option contract. Similarly, changing the level of implied volatility in the currency pair impacts the price of the option as well, whereby the more volatile the currency pair, the more expensive the option premium. In step 3, the ending spot rate can be adjusted to see how changes in the spot rate on the expiration date impact the economic value of the option contract. This tool demonstrates how the option will only be exercised when the strike price is more favorable than the ending spot rate. If the ending spot rate is more favorable for buying or selling the currency than the strike rate, the option finishes "out of the money" such that the maximum loss on the contract is the premium paid. Conversely, if the ending spot rate is less favorable for buying or selling the currency than the strike rate, the option finishes "in the money" and equals a positive value. You can practice pricing foreign exchange options using the Foreign Exchange Derivative Speculator to illustrate the economics and accounting of an option contract, both a put and a call, and to see how variables such as the option strike rate and implied volatility impact the premium or cost of the option at inception. Additionally, you can explore how options can finish "in the money" where a cash payment is received at maturity, or "out of the money" with a zero fair value where no further payment is required to settle the contract. Take advantage of this unique learning resource to discover the three key distinguishing characteristics of vanilla option contracts, which include (1) the premium paid upfront, (2) the asymmetrical payoff profile relative to the spot foreign exchange rate, and (3) the lack of obligation to make a payment at maturity. If you are interested in learning more about option contracts, sign up for FX Initiative's Currency Risk Management Training and benefit from our educational videos and interactive examples. Our course on Foreign Exchange Spot & Derivatives walks you through real-world examples of using derivative instruments, and leverages our Foreign Exchange Derivative Speculator to illustrate essential concepts. Foreign exchange options pricing can be complex, but our approach simplifies the academic theory and focuses on the practical application of using options to help your international organization achevei their foreign exchange risk management objectives. Ready to practice pricing foreign exchange options? Click here to get started! Cheers, The FX Initiative Team support@fxinitiative.com Related Posts FX Strategy Simulation - Option Contracts FX Strategy Simulation - Option Contracts: To illustrate the concept of option contracts, this FX strategy simulation uses the Foreign Exchange Derivative Speculator to model the economic and accounting aspects of a put and a call option. These examples demonstrate the economics and accounting of option contracts, and show how variables such as the option strike rate and implied volatility impact the premium or cost of the option at inception. Additionally, the asymmetrical payoff profile of an option is highlighted using the economic chart, and the accounting is clarified using journal entries and t-accounts. From a cash flow perspective, emphasis is placed on the fact that options can finish "in the money" where a cash payment is received at maturity, or "out of the money" with a zero fair value where no further payment is required to settle the contract. Overall, the three key distinguishing characteristics of vanilla option contracts, compared to forwards and option combinations, are (1) that a premium is paid upfront, (2) there is an asymmetrical payoff profile relative to the spot foreign exchange rate, and (3) there is ... Due Diligence & Distinguishing FX Derivatives Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions. At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives. The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, ... End-of-Year Foreign Exchange (FX) Education With 6 weeks remaining in 2020, take advantage of end-of-year foreign exchange (FX) education by completing our 6 part foreign exchange risk management training program. Whether you need to research a foreign exchange educational topic related to your global business, or want to simulate a foreign exchange risk management strategy using our interactive examples, we offer a wide array of quality informational topics and tools that can help you manage FX risk. FX Initiative is designed to make complex foreign currency matters simple and manageable, and is accessible 24 hours a day 7 days a week to meet your global business needs whenever and wherever a foreign exchange opportunity arises so you can make the right decisions to meet your FX objectives. FX Initiative helps Banking & Treasury Professionals answer FX risk management questions such as: How to manage currency risk? How to draft a FX risk policy? Where to look for FX risk exposures? What currency risks to hedge and how? Which strategies meet FX hedge objectives? What are the economics? How to do FX accounting? Get acquainted with all of the educational topics and interactive examples available exclusively to subscribers. ... Pricing FX Put & Call Options Pricing FX Put & Call Options (Video): Learn the 6 variables that are used to price foreign exchange (FX) options in the Garman-Kohlhagen option pricing model. This video is a preview of FX Initiative’s FX Spot & Derivatives course as part of Learning Objective #2. To learn more, start your FX risk management training today, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples & events at FXCPE.com. Start FX Training Simulating Foreign Exchange Strategies In the field of foreign exchange (FX), companies are managing currency risk exposures and hedging strategies more effectively by using business intelligence (BI) tools that provide data analysis and visualization. To support global businesses, FX Initiative offers a unique suite of specialized simulation tools that model common FX risk management strategies and demonstrate best practices for preserving assets on the balance sheet and mitigating FX gains on losses on the income statement. Our FX Transaction Simulator helps treasury professionals gain valuable insight by modeling the economic and accounting impact of specific hedging strategies for underlying foreign exchange exposures such as revenues, expenses, receivables, and payables. Users can simply input their company specific and foreign exchange market variables, and then test a variety of hedging strategies, which include not hedging or hedging with a forward contract, vanilla option or zero cost collar. The resulting output is a highly detailed interactive FX risk analysis that charts the economic payoff of your selected hedging strategy, ranks the alternative hedging strategies, and reports the accounting journal entries and t-accounts with authoritative references to U.S. generally accepted accounting ... Pricing FX Put & Call Options Pricing FX Put & Call Options (Video): Learn the 6 variables that are used to price foreign exchange (FX) options in the Garman-Kohlhagen option pricing model. This video is a preview of FX Initiative’s FX Spot & Derivatives course as part of Learning Objective #2. To learn more, start your FX risk management training today, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples & events at FXCPE.com. Start FX Training Comments are closed.