Learning Outcomes

• Define an option, and compare and contrast options with other instruments

• Define strike price, market price, the underlying, premium and expiry

• Calculate the cash value of a premium quote

• Describe how OTC and exchange-traded options are quoted, and when a
premium is conventionally paid

• Define call and put options

• Explain the terminology for specifying a currency option

Options • Describe the pay-out profiles of long and short positions in call and put options

• Describe the exercise rights attached to European, American, Bermudan and

Asian (average rate) styles of option

• Define the intrinsic and time values of an option, and identify the main
determinants of an option premium

Learning Outcomes (Continued)

• Explain what is meant by in the money, out of the money or at the money

• Define the delta, gamma, theta, rho and vega

• Interpret a delta number

• Outline what is meant by delta hedging

• Outline how to construct long and short straddles and strangles, and explain
their purpose

• Outline how options can be used to synthesise a position in the underlying asset

• Define an interest rate guarantee FX Options

• Describe the function of cap and floor options, and how they are used to
produce long and short collars

Source: www.aciforex.org

Familiar terminology Familiar terminology

• Vanilla Options • Strike
– Gives its holder (purchaser) all the rights but not the obligation to the − Contract rate of the option, at which transaction will take place if exercised
specific Options
• Premium
• For a buyer, options have unlimited upside and downside is limited
to the cost of the premium
− Amount payable in order to buy the option

• For a seller, options have unlimited downside, and the upside is • Expiry Date
capped at the amount of premium received − The date on which the option will be compared to prevailing market levels
to see if the option will be exercised or not
• The Seller (writer) of an option has the obligation to perform should • In most cases 2 business days prior to delivery date
the option be exercised
• Delivery Date
− This is the date on which the actual flow of currencies from the
transaction happen
Instruments that can be bought or sold Observation profile
• Vanilla Options • European Style
– The decision of whether or not to exercise the option can be done on
expiry date only
• Options are Instruments in their own right
– A Call option can be bought or sold, yet will always reference the right to
BUY the nominated currency if exercised. • American Style
– The decision of whether or not to exercise the option can be done any time
– A Put option can be bought or sold, yet will always reference the right to during the life of the option
SELL the nominated currency if exercised.

Basic Option Terminology The Price Of An Option

• The “Moneyness” of an option strike is observed taking the • There are various components to pricing an option
strike rate of the option in relation to the underlying – Price of the underlying instrument
instrument. – Strike rate of the option
– Time to maturity
– Volatility
• As an example:
– Interest Rates
– In The Money (ITM) = The strike rate of the option is struck at a
rate better than the market reference rate
• Each of these components play an equally crucial role in determining
the price
– Out The Money (OTM) = The strike rate of the options is struck at a
rate worse than the market reference rate
• However, what does the price (premium) of an option truly reflect?

– At the Money (ATM) = The strike rate of the option is struck at the
same rate as the market reference rate • Is that the profit the bank makes?

Exploring price dynamics of

Calls vs. Puts Question
• Time value The seller of a put option has:
– The price one pays for the amount of time available to provide the market
with
a. Substantial opportunity for gain and limited risk of loss
• The opportunity to move and
• The ability of the option to become valuable
b. Substantial risk of loss and substantial opportunity for gain

• Intrinsic value c. Limited risk of loss and limited opportunity for gain
– The value of an option premium which can be measured as the difference
between d. Substantial risk of loss and limited opportunity for gain
• The strike rate and
• Prevailing market rates
Answer Question
The seller of a put option has: The exercise price in an option contract is:

a. Substantial opportunity for gain and limited risk of loss a. The price of the underlying instrument at the time of the transaction

b. Substantial risk of loss and substantial opportunity for gain b. The price at which the transaction on the underlying instrument will be
carried out if and when the option is exercised
c. Limited risk of loss and limited opportunity for gain
c. The price the buyer of the option pays to the seller when entering into
d. Substantial risk of loss and limited opportunity for gain the options contract

d. The price at which the two counterparties can close-out their position

Vanilla Options:
Answer Time value vs.. Intrinsic
IMPORTERS EXPORTERS
The exercise price in an option contract is:
Vanilla $ CALL Vanilla $ Put
Premium Charged Premium Charged

a. The price of the underlying instrument at the time of the transaction 10% 10%

b. The price at which the transaction on the underlying instrument

will be carried out if and when the option is exercised 6% 6%

c. The price the buyer of the option pays to the seller when entering into 2.5% 2.5%

the options contract

d. The price at which the two counterparties can close-out their position

90 100 110 90 100 110

Strike Strike

Note – The volatility skew is not usually symmetrical like this for Put vs.. Call options

The law of one price Synthetic Forward

• What is meant by Put/Call parity • The law of one price plays a vital role in structuring

– Creating a security or portfolio that has a similar return to another security

or portfolio should result in these two assets trading at the same price • It creates pricing rules and balances which affect the way
certain items are priced and used in structures
– IF NOT???

– Arbitrage will cause the market anomalies to be exploited until such time
• Creating a synthetic forward is a good way of showing this
as it corrects

• Using a combination of options we can create a payoff

profile at maturity that exactly matches that of a normal
market FEC
The Relationship Between Call And
Put Delta Structuring using Vanilla Options
• Given that a Synthetic Forward has no optionality (i.e. IMPORTERS EXPORTERS
100% Delta) BUY - $ CALLS BUY - $ PUT

SELL - $ PUT SELL - $ CALL

• Any given strike Call Delta will imply that the No matter which option is exercised, the IMPORTER will always be a
BUYER of USD
No matter which option is exercised, the EXPORTER will always be
a SELLER of USD

+ Vanilla $ CALL + Vanilla $ PUT

– Put Delta = 100 – Call Delta
Buys 100% of Hedged Sells 100% of Hedged
nominal @ Protection nominal @ Spot
Protection Protection
Buys 100% of Hedged Sells 100% of Hedged
– As an example, a 25Delta Call = 75Delta Put, given that the two nominal at @ Spot nominal at @
PROTECTION
options combined creates a synthetic with 100% probability of
exercise - Vanilla $ PUT - Vanilla $ CALL

No Commitment Exists Sells 100% of Hedged

nominal @ Protection
Protection Protection
Buys 100% of Hedged No Commitment Exists
nominal at @
PROTECTION

Creating the first structure Time Value - Long Call

IMPORTER STRUCTURE
BUY - $ CALLS
Option
SELL - $ PUT
Value
CREATING A STRUCTURE WITH THE SAME PAY-OFF PROFILE AS A NORMAL FEC

Long Vanilla $ CALL and sold Vanilla $ Spot = Synthetic Forward

ZERO PREMIUM
SRUCTURE AT SAME Premium
RATE AS THE FEC
Spot

Call Option Exercised – Buys at Protection Time Value

Put Option Expires – No Obligation
BOUGHT USD CALL at 6%
Protection Protection

SOLD USD PUT at 6% Call Option Expires – No Obligation Intrinsic Value

Put Option Exercised – Seller of the option
Buys at Protection

Spot

Strike Price Asset Price

The Relationship Between Call And

Time Value - Long Put Put Delta
CONDITION CALL VALUE PUT VALUE
Option
Value When Price of the underlying rises Rise Fall

When Price of the underlying falls Fall Rise

Premium When Volatility increase Rise Rise

When Volatility decrease Fall Fall

Time Value
Time to maturity increases Rise Rise

Intrinsic Time to maturity decreases Fall Fall

Value
Interest Rates increase Rise slightly Falls slightly

Strike Price Asset Price Interest Rates decrease Falls slightly Rise slightly
 Pay Off Profiles Of Vanilla Call
Pay Off Profiles Of Vanilla Put Options
Options
Profit LONG CALL Profit SHORT CALL LONG PUT SHORT PUT
Profit Profit

Premium
Breakeven Premium Asset price Asset price Breakeven
Strike

0 0 0
0 Breakeven
Asset price Breakeven Strike Asset price
Strike Strike Premium
Premium

Loss Loss
Loss Loss

LONG PUT SHORT PUT

LONG CALL SHORT CALL Loss limited to premium paid Loss limited to between
Loss limited to premium paid Unlimited potential for loss Profit limited to a maximum of breakeven and zero
Unlimited Profit potential Profit limited to premium received breakeven and zero Profit limited to premium received

Pay Off Profile Of A Long Straddle Pay Off Profile Of A Short Straddle
• Simultaneous • Simultaneous sale of
Profit purchase of both a Profit
both a call and put
call and put option, option with the same
at the same strike strike price, notional
price, for the same value, and expiry
notional value, and 0
date
Strike Strike
expiry date
0
• Expect very low
• Expect volatility to volatility during the
be high during the life of the strategy
Loss
life of the strategy
Loss • Maximum profit =
• Maximum loss = premium earned,
premium paid, with with unlimited
unlimited upside downside

Pay Off Profile Of A Long Strangle Pay Off Profile Of A Short Strangle
• Buy a Put at • Sell a Put at
Profit “strike A” and a Profit
“Strike A” and a
Call at “Strike B”, Call at “Strike B”,
with same expiry with same expiry
Strike Strike
date and notional date and notional
0 A
amount.
0 amount.
AssetB Strike
Asset
Strike

Price Price
• Quite a premium A B • This is a strategy
intense strategy so to benefit from low
requires high volatility as one
Loss volatility to be Loss would have
profitable earned a

• Handsome
premium from both
vanilla options
Optionality and the Greeks What does Delta stand for
• Option trades are multidimensional trades • When dealing in options, one quickly realise that the process of
managing the exposure is non-linear
• Does not follow a standard distribution profile or growth pattern
• In other words, position values change at a changing pace throughout
• Greeks aim to measure this time
– Vega (Volatility)
– Delta (Change in price relative to underlying)
• Delta aims to measure the change in the options value (i.e. price)
relative to a change in the underlying instrument, on which the option is
– Gamma ( Relative change in Delta)
based
– Theta (Time value of money)
– Rho (The effects of a change in interest rates on a position)
• In real markets, Delta often takes on a secondary function of referencing
the probability of a strike being exercised
– In other words, an option’s strike price can be statistically calculated to
equate to a probability of exercise given the current volatility parameters.

Delta and risk management Delta and risk management

• When referencing Delta during the process of risk
management, it takes on the form of a balancing act.

• It aims to determine the amount of “underlying” position one

has to have on hand,

• So that the change in the factors effecting the price of the Stock price
going up by $1 I need to be long 100 stocks
option, will cause an equal but opposite change on the
will cause my so that an increase in $1 will
underlying, which when viewed in a portfolio, will net each option to lose cause my stock value to go
other off $100 up by $100

Managing Delta What risk do they need to manage

• Assume an Exporter sells to the bank a European, 3- • “Assume an Exporter sells to the bank a European, 3-month, 25∆ USD
month, 25∆ USD Call Option Call Option”

• “Exporter sells” - the client sold an option, i.e. the bank is buying the
• The option strike is 8.50 option

• Spot at deal time is 8.10 • European 3-month” – the option will be exercised (or expired) in 3
month’s from today “
• The bank assumes a risk which needs to be managed
• “25 Delta” – at a strike rate pitched at a current level which has a 25%
throughout time with the potential for more violence in the probability of being exercised (given current vols)
movement expected the closer we get to the option’s
maturity date. • Call – The option provides the PURCHASER the right to BUY USD
What risk do they need to manage Hedging… at inception
• So if the bank BOUGHT the options from the client, the bank OWNS • Remember, the bank is facilitating a client trade
the USD Call.
• The bank does not necessarily want to BUY USD for their own account
• If at maturity the bank choses to exercise the USD Call, will the bank
be BUYING or SELLING USD? • So if they own an instrument that, when (if) used, will require them to
BUY USD, then they would want to pro-actively enter into an offsetting
• Bank will be BUYING USD if the exercise the USD Call option SALE contract now already

• So if they possibly will be BUYING USD in 3-months’ time, what would • Who knows if the option will be exercised?
be the hedge they have to enter into right this moment?
• As such, they only transact to a value based on the current probability of
• HEDGE IS TO SELL USD exercise (i.e. 25% of the ticket value if the probability of exercise is at 25
Delta)
WHY SELL USD?

Managing Delta – A Non-linear &

Hedging… continuously Continuous Process
• Markets will continue to move up and down throughout the
life of this option
-250,000 @
8.68 Underlying
70∆ 95∆
• As such, the banks would need to adjust their “hedged 8.70
Spot
Movements
amount” as the market moves. 8.60
8.50 Strike
- 100,000 @ -250,000 @
8.40 8.30 8.45 60∆
• This is often referred to as dynamic hedging of a position 8.30 35∆ 45∆
8.20 20∆ +100,000 @
8.30
- 250,000 @
8.10 8.10 +150,000 @
• This process will continue until the day the bank closes the 8.00 25∆
8.15

7.90
option, or its expiration date
TIME TO MATURITY

Long Gamma Theta

• Gamma – an indicator of the change in Delta relative to a change in the • A buyer of option spent money today
underlying
• The buyer of an option usually has a Long Gamma profile • The cost of money is the interest (i.e. negative Time Value i.e. short
• Long Gamma references the position where the “management process” of
Theta)
hedging the Delta creates small profits every time the trader re-hedge.

• As such, a buyer of an option has spent money to buy time

Sell High & Buy Low
Incremental Profits while
hedging • The holder of the option now wish for the market to react volatile in
Long Gamma Profile order to “recover the theta”
− Similarly, a seller of an option has earned the premium (i.e. long
Theta)
− The seller of an option wishes for the market to be subdued in
order to hedge as few times as possible
 The Relationship Between Gamma
Theta And Theta
• Time value is non-linear
A buyer of options usually has a Long Gamma Profile and
• It ticks by, as time goes by, but…
Short Theta Profile
• It ticks by FASTER the CLOSER one gets to maturity of the option
− E.g. EUR call option with a strike of 1.30
− 1 Month to go, and current spot is at 1.29, means quite a lot A seller of options usually has a Short Gamma Profile and
different than the same spot level but only 1 day to go Long Theta Profile
Theta

Maturity

The Relationship Between Gamma And The Effect Of Volatility On An Option

Theta Price
HISTORICAL ACTUAL
IMPLIED VOLS
VOLS VOLS
Hedging Hedging Strike has a low chance of being Strikehas
Strike low chance
hasa aHIGH chance of
of being
being
exercised exercised
exercised

CASH Loss
CASH

Cash

Profi Cas
t h

Long Gamma Short Gamma

Short Theta Long Theta
Trader wants time to continue to hedge Trader wants to just sit on the cash and
not hedge

The Effect Of Volatility On An Option

Price The volatility cone effect
HISTORICAL ACTUAL
• Volatility is most violent in the short dates
VOLS VOLS – The market gives itself some breathing room when it comes to
Strike has a low chance of being Strike has a HIGH chance of being
exercised exercised
longer dated options

Original Volatility levels

New Volatility levels

1 1 1 3 6 12
Day Week Month Months Months Months
Question Answer
An ‘at-the-money’ option has: An ‘at-the-money’ option has:

a. Intrinsic value but no time value a. Intrinsic value but no time value
b. Time value but no intrinsic value b. Time value but no intrinsic value
c. Both time value and intrinsic value c. Both time value and intrinsic value
d. Neither time value nor intrinsic value d. Neither time value nor intrinsic value

Question Answer
The vega of an option is: The vega of an option is:

a. The sensitivity of the option value to changes in interest rates a. The sensitivity of the option value to changes in interest rates
b. The sensitivity of the option value to changes in implied volatility b. The sensitivity of the option value to changes in implied volatility
c. The sensitivity of the option value to changes in the time to expiry c. The sensitivity of the option value to changes in the time to expiry
d. The sensitivity of the option value to changes in the price of the d. The sensitivity of the option value to changes in the price of the
underlying underlying

Interest Rate Caps: Concept

• Insurance against the rate of interest on a floating-rate
loan rising above a certain level

• Level is known as the Cap Rate

Interest Rate Caps & Floors

Interest Rate Caps Caps and floors
• Guarantees the index (Libor) element of the loan rate will be the lesser • Cap
of the prevailing index rate and the cap rate
– Series of (usually consecutive) caplets
– Used to hedge interest rate risk on Libor-based loan value
3-Month $-Libor fixing
– Cap = sum value of each caplet
cap rate
0.35%

• Floor
3-Month fixing dates
– Series of (usually consecutive) floorlets
– Used to hedge interest rate risk on Libor-based investment value
– Floor = sum value of each floorlet

Collar

Interest rates

Cap level
16%

13% Floor level

10%

Time (years)