FX Options

Aashish Pitale

New Delhi
October 10, 2007
Global Markets, India

2
Warm Up
In a Currency Option (say, EUR/USD), a Call is a Put
and a Put is a Call?
True
False



3
Warm Up
In a EUR/USD Option, if a customer is short EUR Put,
at maturity, the customer would:
Buy USD
Sell USD
Buy JPY
Depends


Depends, whether option expires in the money
Sell USD

4
Warm Up
Spot 1.4100, Fwd = 1.4100 (for all tenors) which
option do you think will be more expensive?
1m 1.4150 EUR Call
3m 1.4150 USD Call
3m 1.4150 EUR Call
9m 1.4150 EUR Call
Cant Say





5
Option Basics
Pricing
Volatility
Greeks
Risk Management
Agenda
6
Option Basics
7
FX Options : History

History & Development
Options became popular contracts in 1930s
Black & Scholes transformed the market by giving us
a benchmark pricing theory in 1973
Interbank FX option market launched by 5 banks
(including SCB) in 1982
by late 1980s traders had the computing power to
look at exotic options
1990s saw steady increase in liquidity combined with
more sophisticated pricing models: spreads tighten
and more exotic products become feasible
FAS133 & IAS39 set back market growth, but now
restarting again
8
What is an Option ?

An option contract confers the right,
but not the obligation,
to buy or sell a specific underlying asset
9
Basic Option Terminology
OPTION TYPE
CALL OPTION
PUT OPTION
EXERCISE TYPE
EUROPEAN
AMERICAN
BERMUDAN
10
Basic Option Terminology
STRIKE PRICE
IN THE MONEY OUT OF THE MONEY
AT THE MONEY
OPTION TYPE
VANILLA
BARRIER
DIGITAL
11
Call Option P&L
Pay Off = Max( 0 , S X)
Pay Off
0
Spot, S
Strike, X
P & L
0
Spot, S
Premium, C
Strike, X
OTM : S < X
ATMS : S = X
ITM : S > X
ATMF : F = X
12
Option Vs Forward
Right to buy/sell Obligation to buy/sell
Option Forward
Upfront premium

No premium







Payoff
0
Spot
PREMIUM
Payoff
0
Spot
S
0
13
Pricing and Option Properties
14
Intrinsic and Time Value
Option
Value
FX Rate
Strike
Intrinsic value
Time value
Delta = slope of option
value line
Out of Money In the Money
ATM
15
Boundary Condition
Pay Off


) 0 , ( X S Max Call
T
=
) 0 , (
T
S X Max Put =
16
Time
Value
Intrinsic
Value
+
Time till maturity
Interest Rate
Differential
Volatility
Difference between
strike and spot rate
Option Value

17
Pricing Models
Option price
Binomial model
Monte Carlo Simulation
Black Scholes
Garman Kohlhagen
18
Fundamental Pricing Principle
Price = Expected Discounted Cash Flows
Probability
Present Value
Inflows/Outflows
19
Option Price
| | { } ) 0 , max( X S M E c
T
=
Expected Value
Cash Flow: Pay Off
Multi-period Stochastic
Discount Factor
20
Option Price
| | ) 0 , max( X S E e c
T
rT
=

Present Value
Cash Flow: Pay Off
Probability: Expected Value
21
Option Price
C = N(d
2
)e
rT
[ S*{N(d
1
)/N(d
2
)}e
rT
X]
N(.) - Standard Normal Cumulative Distribution Function
C = SN(d
1
) Xe
-rT
N(d
2
)
Probability of
the option
ending in the
money
Present
Value
Payoff from
exercise given
option ends up in
the money
22
Basic pricing concepts
Option price
Put call parity
| | X F p c
S p X c
rT
T r
rT f
=
+ = +

e
e e
Boundary conditions
) e e , , 0 max( ; 0
rT
T r
X S X S c S c
f

> > >

23
Factors Affecting Option Value
Factor Call Value Put Value
Spot
Strike
Volatility
Domestic Interest Rates
Foreign Interest Rates
24
Volatility
25
Understanding volatility
Volatility
Historical
Implied
Forecasted
Actual
26
Vols
Start, t=0 Start, t=T
S
Implied
Historical
Forecasted
Realized
27
Understanding Volatility
Historical
How volatile was the spot in the past
This is a data analysis question
Standard deviation of continuous spot returns
Implied
Traders estimate of how volatile spot will be
The price of an option is quoted in implied vols
Black-Scholes translates premium into vols

28
Understanding Volatility
Forecasted
How volatile the spot will be till options maturity
This a statistical estimation:
EWMA
GARCH
ARMA
Actual (Realized)
We cannot know this until it is too late!!

29
Implied Volatility (Vol)
Implied Volatility is the one market parameter priced
exclusively by the options market
Vol is a subjective expectation of the degree of future FX
movement
Vol changes over time
Vol is associated with strike
Same Vol for same strike (irrespective of whether the option is call/put)
Different vols for different strikes
Vol is a traded instrument - and the market moves!
Live prices are quoted in premium terms & will change
depending on FX market; a vol price only moves with the
options market
The benchmark vols are for ATM options (50 delta)

30
FX Options : Market Mechanics
The Vol Smile
Normally OTM vols trade above ATM vol
this is due to gap risk (e.g. devaluation), and the higher gearing
of OTM options (the lottery effect)
the butterfly measures this vol premium for OTM options over
ATM vol
(cash value of OTM options will always be less than ATM)

Most FX markets have a bias for calls over puts, or
vice-versa (i.e. they are not symmetrical)
this is due to supply/demand factors, and if there is greater
uncertainty on one side of the FX market
the risk-reversal measures this bias, in terms of the difference
in vol for call and put options
31
Implied Vols v/s Strike
Vol at i l i t y
10
10.5
11
11.5
12
10p 25p ATMF 25c 10c
Simplistic Theoretical Assumption
32
Fat Tails Volatility Smile
Greater Probability of Jumps
10
10.5
11
11.5
12
1
0
p
A
T
M
F
1
0
c
33
5.00%
5.50%
6.00%
6.50%
7.00%
7.50%
1
0
D
1
5
D
2
0
D
2
5
D
3
0
D
3
5
D
4
0
D
4
5
D
5
0
D
4
5
D
4
0
D
3
5
D
3
0
D
2
5
D
2
0
D
1
5
D
1
0
D
Delta
V
o
l
a
t
i
l
i
t
y
25D USD Put
25D USD Call
The BS model is an idealisation of the behaviour of the underlying
asset price, to which the options market makes empirical adjustments
via the Smile.
Delta Smile Parameterization
34
Interbank Volatility Quote


35
Volatility Smile in Practice
25 Delta Strangle
Vols of a 25 Delta Call and a Put
relative to ATM vol
25 Delta Risk
Reversal
Difference between vols of 25 Delta
call and 25 delta put option
ATM Volatility
Volatility of an option with strike
equal to the forward rate
36
Risk Reversal
R/R is collar / range forward
Buy Call & Sell Put or Sell Call and Buy Put
Usually quoted for 25 Delta (both Call & Put)
R/R are Vega neutral hence vol spread is more important than
absolute vol
1m 25d R/R
0.3/0.6 Fav USD Calls, or
0.3/0.6 Fav INR Puts (usually non-USD Ccy), or
0.3/0.6 INR Puts over
Buy USD Calls 0.30 vol higher than USD Put we sell
Sell USD Calls 0.60 vol higher than USD Put we buy
Bid/Offer w.r.t USD Calls
One needs the absolute vol for 25 Delta (either Call or Put) to
know actual vols


37
Strangle/Butterfly/Fly
Straddle Buy Call, Buy Put at same strike K
Strangle Buy Put at Strike A, Call at Strike B (A<B)
25 Delta Strangle
Buy 25 delta Call, say 4.2/4.5
Buy 25 delta Put, say 4.0/4.3
25 Delta Fly (Butterfly)
Buy 25d Strangle, and
Sell ATMF Straddle
25 Delta Strangles are quoted as spread over ATMF
(sell both Call & Put)
1m 25d Strangle
4.1/4.4 absolute vols

38
Strangle / Butterfly
1m 25d Fly in Black Scholes World?


Large positive value of Fly indicates smile with high
curvature
Negative value indicates sad face frown rarely
seen

39
RR & Fly/Butterfly/Strangle - Exercise
Market Quotes:
25 Delta R/R 0.40% USD Call over
25 Delta Strangle 0.7% over ATMF
ATMF 3.5%
Find the following:
25 D Strangle
25 Delta Call
25 Delta Put
40
RR & Fly/Butterfly/Strangle

ATMF -
2
25 25
25
25 25 25

+
=
=
dPut dCall
dFly
dPut dCall dRR

2
25
25 25

2
25
25 25
dRR
dFly ATMF dPut
dRR
dFly ATMF dCall
+ =
+ + =
41
Volatility Surface
Combines volatility smile with volatility term structure
Volatility term structure (Vols v/s Time to Maturity)
Helps to price option with any strike price and any
maturity
The effect of smile decreases as the option maturity
increases



42
EUR/USD Volatility Surface
12.28 11.34 10.63 10.41 10.62 6m
1Y
3M
1M
1W
12.26 11.26 10.55 10.34 10.59
12.26 11.38 10.70 10.48 10.64
12.57 11.75 11.10 10.90 11.04
13.74 13.05 12.50 12.40 12.57
10C 25C ATM 25P 10 P
43
Volatility Cone
Developed by Galen Burghardt
Technique for visualizing current option implied
volatility relative to historic volatility at different
maturity ranges
The maximum, average, minimum volatilities are for
different maturities are plotted for the sample horizon
period

44
Volatility cone : USD/INR
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
1W 1M 2M 3M 6M 1Y
Cur r ent
mean
max/min
45
Greeks and Risk Management
46
Greeks and Risk Management
Change in option value
Change in Volatility
Vega
Change in Interest rate
Rho
Change in Time
Theta
Change in spot
Delta
Gamma
47
Greeks
Vega
Volga
Price
Gamma Vanna
Delta Theta Rho
dGamma/dS dVolga/dV dVolga/dS dGamma/dV
oS
oV
oS oS
oS oS oS
oV oV
oV oV oV
oR
oT
FX Options : Market Mechanics

48
FX Options : Greeks
Black Scholes and Greeks
Option Price
Option Definition
ccy pair
tenor
strike
call / put
Market Variables
spot
forwards
interest rates
volatility
BLACK -
SCHOLES
EQUATION
The greeks:


delta, vega,
rho, theta,
gamma, volga,
vanna & other
market sensitivities
49
Delta
Delta (A) is the rate of change of the option price with respect to
the underlying
Change in option price from infinitely small change in underlying
asset price
Option
price
A
B
Slope = A
Spot price
50
Price
You own $10m of a
$Call Option, K=40
Time
decay
35 40 45
Delta:
+$1m
Delta:
+ $5m
Delta:
+$9m
TV
Delta
Delta
51
Delta
FX Options : Market Mechanics

Delta is the sensitivity of the option price to changes in the
underlying FX rate

Delta represents the proportion of FX that needs to be
bought/sold in order to hedge the FX risk of the option

Delta (for a European vanilla option) also approximately
represents the chance of the option being exercised (i.e.
probability of ending ITM at maturity)

Strikes can be defined in terms of the delta
Delta =
change in value of option
change in FX rate
52
Delta
-
0
.
0
5
-
0
.
0
3
-
0
.
0
1
0
.
0
1
0
.
0
3
0
.
0
5
0.08
0.75
2.00
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Delta
Moneyness
Time (y)
Call Option Delta
0.9-1.0
0.8-0.9
0.7-0.8
0.6-0.7
0.5-0.6
0.4-0.5
0.3-0.4
0.2-0.3
0.1-0.2
0.0-0.1
53
Vega is the sensitivity of the option price to changes in the
implied vol

If you own an option, you will normally be long vega
- i.e. you make money if vols rise, and lose if they fall

Vega is greatest on longer-dated options
Vega =
change in value of option
change in volatility
Vega
FX Options : Market Mechanics
54
Vega As a Risk Measure
Vega is usually expressed as change in value of
option for 1% change in volatility
Volatility is quoted in % annualized terms

Vega hedging is done using another option
If V is the vega of the portfolio and V
t
is the vega of
traded option, then the position of V/ V
t
in the traded
option will make it vega neutral


55
Vega
-
0
.
0
5
-
0
.
0
3
-
0
.
0
1
0
.
0
1
0
.
0
3
0
.
0
5
0.08
0.75
2.00
0
5
10
15
20
25
30
35
Vega
Moneyness
Time
Call Option Vega
30-35
25-30
20-25
15-20
10-15
5-10
0-5
Change in option price due to change in volatility
56
Gamma is the sensitivity of the option delta to changes in
the underlying FX rate

Gamma is the value that can be gained from owning an
option in order to trade the underlying FX rate

If you own an option, you will normally be long gamma
- i.e. you get longer the underlying as spot goes up, and
you get shorter as spot goes down

Gamma is greatest on short-dated options close to expiry
Gamma =
change in delta of option
change in FX rate
Gamma
FX Options : Gamma Scalping
57
Option
Value
FX Rate
Strike
Delta is long - trader
can sell cash to rehedge
Delta is short - trader
can buy cash to rehedge
Gamma trading
FX Options : Market Mechanics
58
Gamma - Price Curvature
Call Option Price and PAY OFF
0
Strike
High
Curvature
Lower
Curvature
59
Gamma as a Risk Measure
Change of delta with price
Large gamma - delta changes very fast
Portfolio has to be made delta neutral very frequently
Measures the curvature of the relationship between
option price and stock price
Curvature leads to hedging error if portfolio is not
frequently rebalanced

60
Gamma - Curvature risk
-
0
.
0
5
-
0
.
0
3
-
0
.
0
1
0
.
0
1
0
.
0
3
0
.
0
5
0.08
0.75
2.00
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Gamma
Moneyness
Time (y)
Call Option Gamma
0.9-1.0
0.8-0.9
0.7-0.8
0.6-0.7
0.5-0.6
0.4-0.5
0.3-0.4
0.2-0.3
0.1-0.2
0.0-0.1
61
Vanilla Greeks
LONG CALL
+ Delta
+ Gamma
+ Vega

SHORT CALL
- Delta
- Gamma
- Vega


LONG PUT
- Delta
+ Gamma
+ Vega

SHORT PUT
+ Delta
- Gamma
- Vega
62
Theta is the sensitivity of the option price to changes in time:
as time only goes in one direction, this is normally known
as time decay

Short theta is normally balanced against long gamma
positions

Theta is the day-to-day cost of owning options: the price of
an option is determined by the perceived benefit of
owning the gamma versus the cost of the theta

Theta =
change in value of option
change in time to expiry
Theta
FX Options : Market Mechanics
63
Theta as a risk measure
Theta is usually negative for an option
As the time to maturity decreases option becomes
less valuable (Theta Decay)
Theta has greatest impact on short-term options
No uncertainty about the passage of time
Theta indicates that the value of position will grow at
risk free rate if both delta and gamma are zero
If Theta is large in absolute terms, either delta or
gamma must be large



64
Option Portfolio
Portfolio of Calls / Puts of different strikes, different
maturities, different notional, different sides (buy / sell)
Portfolio Risk Management => Greeks !
Greeks are additive
Portfolio Delta = Sum of Deltas of all options (with
appropriate signs)
Similarly, Portfolio Gamma, Portfolio Vega, etc

65
Thanks, no questions please !!