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Acf305: International Financial and Risk Management

1. The document provides an outline and summary of topics covered in Lecture 6 on international financial and risk management. 2. Key topics included a reminder of call and put options, the institutional features of options markets, important arbitrage relationships and deriving put-call parity, and using options to hedge currency exposure or speculate. 3. Students were assigned to read the relevant chapter and provided additional reading to enhance their understanding of using options in currency markets.

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Simon Gathu
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© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
47 views

Acf305: International Financial and Risk Management

1. The document provides an outline and summary of topics covered in Lecture 6 on international financial and risk management. 2. Key topics included a reminder of call and put options, the institutional features of options markets, important arbitrage relationships and deriving put-call parity, and using options to hedge currency exposure or speculate. 3. Students were assigned to read the relevant chapter and provided additional reading to enhance their understanding of using options in currency markets.

Uploaded by

Simon Gathu
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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AcF305:

International Financial and Risk


Management
Lecture 6

1
Outline of Lecture 6
• Essential reading: Chapter 8 of Sercu (2009).
• Topics:
− Reminder: What are options? How are call and put options different?
− What are institutional features of the options market?
− What are important arbitrage relationships in the options market?
How can we derive the put-call parity from these arbitrage relations?
− How can we use options to hedge an exposure we have in a foreign
currency? How can we use an option to speculate on the value of a FC?

2
Reminder of the Definition of Option Contracts
• So far studied: symmetric contracts, e.g. forwards or futures.
− Example long forward: ValueFC ↑ (↓) ↔ Valueforward ↑ (↓).

• Options have asymmetric payoffs, e.g. gain on the upside (e.g. when ValueFC
↑) & don’t lose on the downside.

• Some definitions:
− Call (put) option gives holder the “right” to buy (sell) a specified number of
the underlying asset at a specified price at or before the maturity date.
− At maturity → European-style; up until maturity → American-style.
− Specified price: often referred to as strike price.
− Underlying asset: stock, index, currency, interest rate, etc.

3
Reminder of the Definition of Option Contracts

• An agent will only exercise his right at maturity if this is beneficial.


− You only buy using the call option if this is cheaper than buying
in the market (at the spot rate ST).
− You only sell using the put option if this gives you more money
than selling in the market (at the spot rate ST).

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X=0.50

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Early Exercise & Option Premium

• American-style options can be exercised early (at τ < T). When would a
rational agent perform an early exercise?

Condition 1 The immediate payoff (e.g. Sτ − X for call) must be positive


→ same as at maturity.

Condition 2 The option value at τ (= market price) is lower than the


immediate payoff − (ARBITRAGE)

6
Early Exercise & Option Premium

• Purchasing an option is like taking out insurance.

− Example: A knows he will have to buy CHF at T: he buys a call option to


insure that the price is no higher than the strike.

− Example: B knows she will have to sell CHF at T: she buys a put option
to insure that the price is no lower than the strike.

• As insurance is costly, the option buyer needs to pay a price (= premium) to


the option seller (= writer).

Option writers sell options in exchange of a premium from buyers.


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Jargon
• Moneyness: Relates to the immediate payoff of an option (even if it cannot
be realized, as for European-style options).
− At-the-money: spot price is equal to strike price.
− In-the-money: immediate exercise generates a positive cash flow.
− Out-of-the-money: immediate exercise generates a negative cash flow.
• Intrinsic value: reveals the immediate payoff of an option.
− Example call: (St − X)+.
− Only difference to maturity payment: St instead of ST.
• Note: Even deep out-of-the-money options will have a strictly positive value (=
market price).
− While early exercise has zero value, option could still become profitable later
on.
Option value = Intrinsic value + Time value. 9
Institutional Features of Option Markets
• Options are available both in over-the-counter markets (OTC options) and
on organized exchanges (traded options).
• Traded options:
− Organized secondary market with clearing house as guarantor.
− Standardized in many aspects: (1) expiration dates, (2) contract sizes
and (3) exercise prices.
− Example USD/EUR options:
• Expiration dates: 1-3 months (all months); 3, 6 and 9 months (Mar,
Jun, Sep, Dec); 3 years (Sep).
• Contract size: USD 10,000.
• OTC options:
− Sold by financial institutions, price quoted two-ways.
− Like forward contracts: tailor-made.

10
Arbitrage Relationships for Options I

• Assume:
1. American-style option premia: !"&' and ("&'
2. European-style option premia: Ct and Pt
Relation 1: Option prices are non-negative
!" ≥ 0, !"&' ≥ 0 and (" ≥ 0, ("&' ≥ 0

• Explanation: The payoff of a degenerate option is nonnegative, so buy


infinite amount if price is negative.

Relation 2: American options are worth no less than European options


!"&' ≥ !" ≥ 0 and ("&' ≥ (" ≥ 0

• Explanation: American option = European option + right to exercise before


maturity.
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Using Options for Speculation on FX Changes

• Options can be used to speculate on changes in the exchange rate:


− A is bullish about the future prospects of FC → he buys a call option on
the FC (and hopes that it will end up in-the-money).
− B is bearish about the future prospects of FC → she buys a put option
on the FC (and hopes that it will end up in-the-money).

• Traders can also sell (instead of buy) options to speculate on changes in the
exchange rate:
− A is bullish about the future prospects of FC → he sells a put option on
the FC (and hopes that it will expire unexercised).
− B is bearish about the future prospects of FC → she sells a call option
on the FC (and hopes that it will expire unexercised).

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X=10

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Summary, Homework and Additional Reading
• In this lecture, we dealt with:
− A review of basic option concepts & a reminder of option jargon.
− The institutional features of the options market.
− Some important arbitrage relationships, their derivation and the
concept of put-call parity.
− The use of options for hedging or even speculation.
• At home, you will need to cover:
− Carefully read the chapter from the book.
• Additional reading:
− Kritzman, M. (1992), “What Practitioners Need to Know...About
Currencies”, Financial Analysts Journal 48(2), 27-30.

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