AcF305:
International Financial and Risk
Management
Lecture 6
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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?
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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.
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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)
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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.
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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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