Foreign exchange option

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Foreign Exchange

Exchange Rates Currency band Exchange rate Exchange rate regime Fixed exchange rate Floating exchange rate Linked exchange rate

Markets Foreign exchange market Futures exchange

Products Currency Currency future Forex swap Currency swap Foreign exchange option

See also Bureau de Change

In finance, a foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC but a fraction is traded on exchanges like the Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts.

For example a GBPUSD FX option might be specified by a contract allowing the owner to sell £1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 GBPUSD or 0.5000 USDGBP and the notional is £1,000,000. This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market participants. If the dollar is stronger than 2.0000 GBPUSD come December 31 (say at 1.9000 GBPUSD) then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 - 1.9000)*1,000,000 GBP = 100,000 USD in the process. If he or she immediately exchanges their profit, this amounts to 100,000/1.9000 = 52,631.58 GBP.

Contents 1 Valuing FX options: The Garman-Kohlhagen model 2 Examples 3 See also 4 External Links

[edit] Valuing FX options: The Garman-Kohlhagen model

As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of an european option on a FX rate is typically calculated by assuming that the rate follows a log-normal process.

[edit] Examples

may rate

N is the cumulative normal distribution function

r_d is domestic risk free rate

r_f is foreign risk free rate

and σ is the volatility of the FX rate.

[edit] See also

• Put option
• Call option
• Foreign exchange market

[edit] External Links

• Online Exotic FX Option Calculators, sitmo.com

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