FX Currency Options

In this article, we wanted to look at FX currency options, which is the term used for “foreign exchange options.”  For starters, in the world of finance,
FX currency options, which are sometimes referred to as currency options or foreign exchange options, is a financial tool used that gives a person the right but not obligation to exchange money of one currency into money of another currency.  This exchange would be based on an agreed upon exchange rate that would go into effect on a specific date.

Of all markets for options, FX currency options are by far the largest and liquid in the world.  The majority of FX option volumes are traded in over-the-counter finance or OTC, which is slightly regulated.  However, a small portion of FX options is traded on future contracts to include exchanges such as the Philadelphia Stock Exchange, Chicago Mercantile Exchange, or International Securities Exchange.  When looking at exchange traded options globally, the value just five years ago was more than $158 billion according to the Bank for International Settlements.

Additionally, for FX currency options, several subtleties are included.  A few examples of these include the following:

•    Ratio of Notionals – Within an FX currency option could be the Ratio of Nationals, which is the strike, meaning it is not a forward or current spot.  In this case, when trying to develop a strategy from FX currency options, you need to be cautious that foreign currency notionals are matched instead of local currency notionals.  Otherwise, foreign currencies being received and delivered would not offset, meaning you would be facing some degree of residual risk.

•    Non-Linear Payoff – This strategy for FX currency options is neutral and used when one currency denominates the paying regardless of numeraire.  If using an FX option on a rate, you would need to be able to distinguish between underlying and numeraire currencies.

•    Numeraire Change – Any FX currency options that imply volatility, the purchaser’s numeraire would be an important factor because of non-linearity.

For FX currency options, it is common for corporations to go this route to hedge any future cash flow in a foreign country’s currency that is uncertain.  Although there are different possibilities, most will hedge specific currency cash flows using forwards while options would be used for foreign cash flows with uncertainty.  Generally, if a cash flow were uncertain, the corporation would use certain options.  For instance, if a forward FX contract were entered, and any anticipated cash flow in United States dollar cash was not received, the organization would be exposed to FX risk in the opposite direction with the forward, not hedging.

When it comes to the standard model for calculating FX currency options, the Garman-Kohlhagen or GK is used.  Of course, other techniques are available for calculating risk exposure of options as well.  Keep in mind, that in this case price calculated for all models would agree but the risk numbers that are calculated using a variety of models would likely have significant variance depending on assumptions used.