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Currency options: from inception to present.

For some time multinational corporations have hedged foreign exchange risks with forward or futures contracts. These contracts are agreements to buy or sell a given amount of foreign currency at a specified exchange rate at some future date. Forward and futures contracts involve not only the right but also the obligation to deliver at maturity of the contract. However, there is the possibility of large losses should the position have to be closed out in an adverse market. By contrast, losses on options are limited to the original premium paid.

A foreign exchange option is a contract that allows the holder to purchase or sell a designated quantity of foreign currency at a specified price or exchange rate up to a specified date. A call option gives the purchaser the right to buy the currency by exercising the option. The last date on which an option can be exercised is known as the expiration or maturity date. The price or exchange rate at which the specified foreign currency can be bought or sold is called the strike price or exercise price. If an option can be exercised at any time up to and including its expiration date, it is called an American option. If it can be exercised only at the expiration date, it is called a European option. The option buyer purchases the right to buy or sell currency at the exercise price; the party granting this right is the option seller or writer. The right to buy foreign currency (a call option) is also the right to sell domestic currency (a put option).

To acquire the benefits granted in a call option, the buyer must pay the seller a premium, the option price. By receiving this premium, the seller of the option must fulfill the obligations specified in the contract at the request of the buyer.

At expiration, the value of a call option is determined by the spot exchange rate and the exercise price. Figure 1 plots the payoffs to a sterling call option buyer and a call option writer at the option's expiration date against possible sterling spot prices. For sterling spot prices below the exercise price, the call option is said to be out of the money. The holder will not exercise the option because the sterling can be bought cheapor in the spot market. The option holder will take a loss which will be limited to the premium paid for the option. For sterling spot prices above the exercise price, the option is said to be in the money. The holder of this option makes a profit by exercising it at expiration and thereby purchases the sterling at a cheaper price as agreed upon in the option contract instead of in the spot market at a more expensive exchange rate. When the sterling spot price is the same as the exercise price, the option is said to be at the money.

Buying at the exercise price and selling at a higher spot price results in a profit. The higher the spot price over the exercise price, the larger the holder's profit. When the spot price exceeds the exercise price only by an amount equal to the premium paid, the call option holder breaks even.

The payoffs to the call option seller are the opposite of those to the option buyer. The maximum profit the seller can make is the premium received; any gain to the holder is a loss to the seller. If the option expires unexercised, the seller profits by the full amount of the premium. Similar payoffs profiles can be constructed for two other basic option positions, buying and selling a put (see Figure 2). In the case of buying a put option, i.e., the right to sell a currency at a fixed price on some future date without the obligation to sell, the buyer can have the chance to make unlimited profits should the underlying currency strengthen and limit loss. The breakeven point in Figure 2 shows where the pound sterling has appreciated sufficiently enough to compensate for the initial premium paid out. Referring to the final case of selling or writing a put option, the option writer earns the premium, but accepts substantial risk should the pound sterling depreciate.

Option strategies to hedge foreign exchange risks can use any combination of these four fundamental positions; i.e., buying a call, buying a put, selling a call, and selling a put. For example, the combination of buying a call option and selling a put option at the same strike price for the same maturity is the equivalent of buying the currency forward at that strike price. This is so because one will gain by the amount the currency's spot price is greater than the strike price for the call option and, analogously, lose with the sale of the put option by the amount the currency falls below the strike price at maturity. Therefore, this strategy of combining two options is the same as buying the currency forward at a contracted forward rate or, in the case of options, at the strike price.

Foreign currency options allow users to gain from fluctuations in exchange rates while limiting the risk of adverse currency movements. Options also serve important and unique functions that forward and futures contracts cannot duplicate. Because the options convey the right, but not the obligation to buy or sell the underlying currency, the foreign exchange transaction does not have to be honored if a deal falls through. To illustrate, an American company bidding for the purchase of land in France for payment in French francs can purchase put options on the franc/dollar exchange rate if he fears that the franc will depreciate before the consummation of the bid. This gives him the right to sell French francs for dollars at a specified exchange rate and insures that French francs will be worth at least the option exercise price, less the premium. If the American company does not win the bid, or if the franc appreciates against the dollar, the cost of his insurance will be limited to the cost of the premium. 1f the American company feared that the French franc would appreciate against the dollar, it could have purchased a call option, the right but not the obligation to buy francs. In this case, if the bid was lost, or the franc depreciated against the dollar; the cost will only be the premium.

Foreign currency options, particularly American options, are also useful when the hedger is uncertain about the date when the foreign currency will be needed. In such cases, currency options should be bought with a maturity extending beyond any possible date of need. If the deal does not materialize before the option's maturity date, the option can be exercised to generate relevant foreign exchange. While the premium price is greater at more distant expiration dates, it can be viewed as the cost of uncertainty and must be weighed against the benefits that the hedger derives from using options in this manner.

Other international market participants can also benefit from using foreign currency options in managing their foreign exchange risks. Corporations can use options to hedge against foreign currency payables and receivables. International investors can protect the value of their multicurrency investments with appropriate positions in foreign currency options. Money market instruments, foreign equity and bond portfolio investments can be protected with options. Finally, importers and exporters can insulate their international transactions against adverse currency fluctuations while gaining the potential for profit.

The Philadelphia Stock Exchange

The Philadelphia Stock Exchange was the first to trade currency options. On December 10, 1982 the Philadelphia Exchange started trading options in the pound sterling. The pound sterling was the first currency to be traded since it is the most heavily traded in the United States interbank foreign exchange market. In January of 1983 options on the Japanese yen and Swiss franc started trading. In February of 1983 option trading also began in the German mark and Canadian dollar. Almost two years later, on September 17, 1984, the Philadelphia Stock Exchange began trading options in French francs. More recently, on February 12, 1986, options in the European Currency Unit (ECU) began trading. Finally, the last currency introduced by the Philadelphia Stock Exchange was the Australian dollar which began trading on January 19, 1987. The Philadelphia Stock Exchange currently trades both European and American options.

Each of the option contracts has a trading unit equal to one half the size of foreign currency futures contracts on the IMM, (International Money Market.) Therefore the size of the Sterling option contract is BP31,250 and the others are: DM62,500, C$50,000, Yen6,250,000, SF62,500, FF125,000, ECU62,500 and A$50,000.

These sizes of the option contracts are based primarily on the fact that stimulation studies show that anticipated premiums on contracts of the aforementioned size are comparable to options on equities. Secondly, the option contract size is easy to calculate in relation to a foreign exchange futures contract. This point should encourage arbitrage between the option market and the foreign exchange futures market on the IMM. Finally, the Philadelphia Stock Exchange believes that the contract size is small enough to appeal to retail firms, while large enough to be economically attractive to larger institutions.

As in the futures market, the currencies are quoted in American or U.S. dollar terms, (dollars per unit of foreign currency), even though European or local currency terms, (units of foreign currency per dollar), are used in the interbank foreign exchange market for all currencies in dollar terms simplifies the clearing and margining of foreign currency transactions on organized exchanges.

Finally, each currency has expiration dates approximately three months apart with expirations in March, June, September and December, in addition to the two nearest term months. The expiration cycle rotates and has maturities of 1,2,3,6,9, and 12 months.

The Chicago Mercantile Exchange

In January 1984 the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange (CME), introduced options on Deutschemark futures contracts. An option on a futures contract involves buying and selling puts and calls on a contract that upon delivery yields an IMM futures contract rather than the currency itself. When exercised, the holder of the option receives a short or long position in the currency futures contract which expires one week after the expiration of the option contract.

Options on futures are traded on the following six currencies: British pound, Canadian Dollar, Deutschemark, Japanese yen, Swiss franc and Australian dollar. The lot sizes for the options on futures are the same as currency futures contracts, namely: BP62,500, C$100,000, DM125,000, Yen12,500,000, SF125,000, and ASIO0,000.

Over the Counter Options

Over the Counter (OTC) options, as their name implies, are options which are not traded on an organized exchange. They are customized options which are usually bought or sold by commercial bank, financial institutions and multinational corporations. Over the counter options can be tailored to the individual needs of the corporate clien;or example, as discussed above, exchange traded options on the Philadelphia Stock Exchange are for a specific amount, specific maturity and specific strike price interval. This is in contrast to an over the counter option which can be tailor made for a specific amount, maturtty and strike price.

Over the counter activity is concentrated in New York and London and usually involves the major currencies. They are customarily traded in round lot sizes of five to ten million dollars. The average maturity of over the counter currency options is between two and six months. There are, however, banks and financial institutions that write long term options, extending for several years. American over the counter options are the most common in New York while European options are popular in Germany and throughout Europe.

The over the counter market consists of two sectors, a retail market and a wholesale market. The retail market is composed of corporate clients who purchase options from banks in what amounts to tailored insurance against adverse currency movements. The wholesale market exists among commercial banks, investment banks and brokers who deal with interbank over the counter trading.

Finally, over the counter options have the advantage of trading twenty four hours a day, unlike exchange traded options which trade only during certain hours.

While exchange traded options gear themselves to the smaller players in the market as evidenced by the average contract size of $50,000, the over the counter market appeals to larger institutions with the average contract size $5 to S10 million. Both the over the counter market and the exchange traded options market tend to enhance the overall activity of currency options trading and new product development.


1. Brady, Simon, "Over the Counter or on the Exchange?", Euromoney Publications, November 1990, 62-64.

2. Cox, John C. and Mark Rubenstein, Options Markets, New Jersey: Prentice-Hall, Inc., 1985.

3. Gastineau, Gary L., The Stock Options Manual, New York: Mcgraw Hill Book Company, 1979.

4. Tucker, Alan L., Financial Futures, Options, and Swaps, Minnesota: West Publishing Company, 1991.
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Title Annotation:foreign currency exchange
Author:Pasmantier, Anita B.
Publication:Review of Business
Date:Mar 22, 1992
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