Foreign exchange operations :
Forward exchange
A forward contract consists of a purchase or a sale of currency (foreign currency) against another currency (functional currency) at a determined date and at a predefined rate. It is a contract between two parties, the forward buyer of the foreign currency and the forward seller of the same currency. The forward rate is calculated on the basis of the spot rate at the time the transaction is stopped as well as on the interest rate differential between the foreign and functional currencies which allows to calculate the swap points and therefore the forward rate.
A currency option is a financial contract between two parties, the buyer and the seller of the option.
The buyer of the option has the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put):
– a specified amount of a processed currency (foreign currency) against another currency (functional currency)
– on a specified date, called the “exercise date”.
– at a specific price, called a “strike”.
Foreign exchange options from simple to complex
- European call/put: these are the most common options and are the ones most often used, along with forward contracts, as part of currency hedging strategies. A European Call/Put is an option that can only be exercised on the option’s maturity date. Valuing these products is in theory fairly simple since this valuation is obtained using a so-called “closed” formula. On the other hand, getting the right price is much more complicated, because the added value is not in the model itself (“Black and Scholes”) but in the parameters used in the model. DeftHedge uses for these options, as for all those that are then detailed, the implicit interest rates to calculate the drift as accurately as possible and recalculates for each maturity and each strike price the delta of the options allowing for the optimal integration of the volatility “smile” in the valuation.
- American Call/put: These options are identical to European options, with one exception: the exercise of an American option can take place at any time between the purchase/sale of the option and its exercise date. The valuation model used in this case is much more complex because there is no closed formula for valuing such a product.
- Asian call/put or average call/put: unlike the European and American options described above, the exercise of an Asian call or put does not depend on the underlying spot rate at the option’s maturity date but on the average of the underlying spot rate over a given period. These options can be considered as part of a currency hedging policy when the purchases/sales of currencies are made in a linear fashion over a given period. An Asian call/put option avoids the need to trade one option per day.
European currency options may also incorporate an activation/deactivation factor (“barrier”). The barrier is a certain level above (“up”) or below (“down”) which an option activates (“in”) or deactivates (“out”). These options are necessarily less expensive than plain vanilla options with the same characteristics because they can be deactivated (in the case of “out” options) or do not yet exist (in the case of “in” options).
Currency Barrier Options
- American Barrier: the barrier is tested at each point in time between the treatment date and the exercise date. This style of exercise is the most common.
- European barrier: the barrier is only tested at the date of exercise*
- Partial start : like the American barriers, partial-starts are tested at every moment. On the other hand, the test period does not take place between the processing date and the option exercise date, but between the processing date and a specific date between the processing date and the exercise date
- Partial-end: like the American barriers, partial-starts are tested at each point in time. However, the test period does not take place between the processing date and the exercise date of the option but between a specific date between the processing date and the exercise date and the exercise date itself.
- Window : it is a combination of partial start and partial end, the barrier being tested between a predetermined date (“start”) between the processing date and the exercise date and another predetermined date (“end”) between the “start” and the exercise date.
American Barrier Options can also be offered as Double Barrier Options, i.e. with two levels above or below which the options can be activated or deactivated.
The valuation models for these complex options are proven and identical to those used by the largest banks. The bank commercial margins being higher on these products than on plain vanilla products, valuation differences can be observed between the DeftHedge pricer and the quotes obtained from your banking partners: these differences are not linked to the models themselves nor to the input parameters but to the complexity for the banks to cover these products and therefore to the need for them to downgrade the quotes.
Other types of currency options available
Option on option: these options are increasingly used because they fit perfectly into the framework of a balanced hedging management policy. They are options for which the underlying asset is not an exchange rate but another option. They are composed of a parent option and a daughter option. The daughter option is a European plain vanilla option. The purchase of an option simply consists of acquiring the right, on the exercise date of the parent option, to purchase another option (the daughter option) at a price determined when the option is put in place.
There are four types of option on option that exist :
- Call on Call: Buying/selling a call on call is buying/selling the right to buy a call
- Call on Put: buying/selling a call on put consists in buying/selling the right to buy a put
- Put on Call: buying/selling a put on a call is buying/selling the right to sell a call
- Put on Put: Buying/selling a put on put is buying/selling the right to sell a put
- Digital (binary) option: A digital option is similar to a plain vanilla option except that a specified amount (“payoff”) is due at the time of exercise. Digital options can be European, American or barrier options.
- Lookback option: The lookback option allows to buy currencies on the basis of a strike price corresponding to the lowest price during the life of the option (“call”) and to sell on the basis of a strike price corresponding to the highest price during the life of the option (“put”). :
If you need further information, please do not hesitate to contact us. contact@defthedge.com
DeftHedge offers a tool “the pricer” which allows to calculate the prices of all the above mentioned instruments.