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”.
- Call/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.
: unlike the European and American options described above, the exercise of an Asian call or put is not a function of the underlying spot price on the maturity date of the option but a function of the average of the underlying spot price over a given period. These options may be considered in the context of a currency hedging policy when currency purchases/sales are made on a linear basis over a given period. An Asian call/put avoids having to deal with 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).
- 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
- 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: the purchase/sale of a call on call consists in buying/selling the right to buy a call
: the purchase/sale of a put on call consists in buying/selling the right to sell a call
: the purchase/sale of a put on put consists in buying/selling the right to sell a put
li><Digital option (binary) : a digital option is similar to a plain vanilla option with the difference that in case of exercise, a certain amount (“payoff”) is due at the time of exercise. Digital options can be European, American and barrier options.
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DeftHedge offers a tool “the pricer” which allows to calculate the prices of all the above mentioned instruments.