CURRENCY OPTIONS

Overview

A currency option is no different from a stock option except that the underlying asset is foreign
exchange. The basic premises remain the same: the buyer of option has the right but no obligation
to enter into a contract with the seller. Therefore the buyer of a currency option has the right, to his
advantage, to enter into the specified contract.

In every currency transaction, one currency is bought and another sold. For example an option to
buy US dollars (USD) for Indian rupees (INR) is an USD call and an INR put. Conversely, an
option to sell USD for INR is an USD put and an INR call. The other basics like strike price,
expiration period, American style or European style are similar to stock options.

Quotation of a currency option can be done in two ways: American or direct terms, in which a
currency is quoted in terms of the Indian Rupees per unit of foreign currency; and European or
inverse terms, in which the Rupee is quoted in terms of units of foreign currency per rupee. The
same applies to situations where the Indian Rupee is not one of the currencies.

Option Pricing

The premium quoted for a particular option at a particular time represents a consensus of the
option's current value which is comprised of two elements: intrinsic value and time value. Intrinsic
value is simply the difference between the spot price and the strike price. A put option will have
intrinsic value only when the spot price is below the strike price. A call option will have intrinsic
value only when the spot price is above the strike price. Options, which have positive intrinsic value,
are said to be "in-the-money".

When the price of a call or put option is greater than its intrinsic value, it is because of its time value.
Time value is determined by five variables: the spot or underlying price, the expected volatility of the
underlying currency, the exercise price, time to expiration, and the difference in the "risk-free" rate
of interest that can be earned by the two currencies. Time value falls toward zero as the expiration
date approaches. An option is said to be "out-of-the-money" if its price is comprised only of time
value. A variety of complex option pricing models such as Black-Scholes and Cox-Rubinstein have
been developed to determine option pricing. Another commonly used model for currency option
valuation is the Garmen-Kohlhagen model.

Interest rate differentials between nations and temporary supply/demand imbalances can also have
an effect on option premiums. In the final analysis, option prices (premiums) must be low enough to
induce potential buyers to buy and high enough to induce potential option writers to sell.

Types of Options

Apart from the normal call and put the following are a few basic types of currency options. In real
life most of the options are combinations of these basic types.

Knock-Out Options
These are like standard options except that they extinguish or cease to exist if the underlying market
reaches a pre-determined level during the life of the option. The knockout component generally
makes them cheaper than a standard Call or Put.

Knock-in Options
These options are the reverse of knockout options because they don't come into existence until the
underlying market reaches a certain pre-determined level, at this time a Call or Put option comes
into life and takes on all the usual characteristics.

Average Rate Options

The options have their strikes determined by an averaging process, for example at the end of every
month. The profit or loss is determined by the difference between the calculated strike and the
underlying market at expiry.

Basket Options
A basket option has all the characteristics of a standard option, except that the strike price is based
on the weighted value of the component currencies, calculated in the buyer's base currency. The
buyer stipulates the maturity of the option, the foreign currency amounts which make up the basket,
and the strike price, which is expressed in units of the base currency.
Currency Options in India

Currency options are new comers in the Indian scenario. The Reserve Bank of India (RBI) allowed
trading in rupee options from July 7th, 2003. The timing could not have been more appropriate with
the government having a comfortable forex reserves position and markets mature enough to be able
to exploit the opportunity. On the first day it witnessed brisk activity (trading volumes of $200-250
million with foreign as well as Indian banks like Standard Chartered, HSBC, ABN Amro, SBI, IDBI,
ICICI Bank and IndusInd entering into major transactions. Big corporate houses like Reliance,
HCL, Murugappa and L&T were also not far behind.

Before the introduction of currency options the Indian corporates had only two alternatives: either
to enter into a forward contract or leave the exposure open. The problem with forwards is that they
are price fixing agreements and deny any gains of favorable movement in the market. Leaving the
exposure open subjects them to the mercy of the market.

Options are like insurance contracts, they protect you from the downside at the same time allowing
you to reap the benefits of any upside. Allowing Rupee options would introduce greater flexibility in
risk management of corporates and cost control.

CHETAN JAIN

Resources:

1. http://pbfg.de/eng/financial2-3.htm
2. www.ozforex.com.au
3. www.indiainfoline.com
4. www.rbi.org.in
5. www.blonnet.com