Options and their effect on currencies

Options are like magnets they tend to create battles between buyers and sellers. They can hold or draw currencies towards the expiry time, which is at the NY cut 10:00 am (14:00GMT) each week day. Depending on the size, large being $500m +, you will often see the price gravitate towards the expiry price as the battle between buyers and sellers ensues. The prevailing market sentiment plays a large part on any impact so bear this in mind as it’s not an exact science.

Below is an overview from Wikipedia explaining in detail options and their relationship with FX.

In finance, a foreign-exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the owner 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.[1] See Foreign exchange derivative.

The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158.3 trillion in 2005.

For example a GBPUSD contract could give the owner the right 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 USD per GBP (or GBP/USD 2.00 as it is typically quoted) and the notional amounts (notionals) are £1,000,000 and $2,000,000.

This type of contract is both a call on dollars and a put on sterling, and is typically called a GBPUSD put, as it is a put on the exchange rate; although it could equally be called a USDGBP call.

If the rate is lower than 2.0000 on December 31 (say at 1.9000), meaning that the dollar is stronger and the pound is weaker, then the option is 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 GBPUSD – 1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they immediately convert the profit into GBP this amounts to 100,000/1.9000 = 52,631.58 GBP.

  • Call option – the right to buy an asset at a fixed date and price.
  • Put option – the right to sell an asset a fixed date and price.
  • Foreign exchange option – the right to sell money in one currency and buy money in another currency at a fixed time and relative price.
  • Strike price – the asset price at which the investor can exercise an option.
  • Spot price – the price of the asset at the time of the trade.
  • Forward price – the price of the asset for delivery at a future time.
  • Notional – the amount of each currency that the option allows the investor to sell or buy.
  • Ratio of notionals – the strike, not the current spot or forward.
  • Non-linear payoff – the payoff for a straightforward FX option is linear in the underlying currency, denominating the payout in a given numéraire.
  • Numéraire – the currency in which an asset is valued.
  • Change of numéraire – the implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of x \mapsto 1/x.

The difference between FX options and traditional options is that in the latter case the trade is to give an amount of money and receive the right to buy or sell a commodity, stock or other non-money asset. In FX options, the asset in question is also money, denominated in another currency.

For example, a call option on oil allows the investor to buy oil at a given price and date. The investor on the other side of the trade is in effect selling a put option on the currency.

To eliminate residual risk, match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don’t offset.

In the case of an FX option on a rate, as in the above example, an option on GBPUSD gives a USD value that is linear in GBPUSD using USD as the numéraire (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 / $2.0000 = $100,000 profit), but has a non-linear GBP value. Conversely, the GBP value is linear in the USDGBP rate, while the USD value is non-linear. This is because inverting a rate has the effect of x \mapsto 1/x, which is non-linear.

Source: Wikipedia

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