ClassCurrencyOptionsCh8.docVIP

Class #6, 7: FX Options, page PAGE8 Class Currency Options Ch 8  TOC \f Introduction 2 Definitions 2 Call options 2 Example of Call option 2 Payoff diagram for a call option 2 Put options 2 Example of a put 3 Example of fx put option 3 Payoff diagram for a put option 3 Advantages of options over forwards and futures 3 Payoff charts 3 Elementary positions 4 Ratio hedges 5 Combinations 6 Hedged positions 6 Applications of options and futures 6 Example 1: Using options to set a ceiling on a fx payment 6 Example 2: Using put options to set a floor on a fx receivable 7 Example 3: Writing options to hedge against fx risk. 8 Example 4: Using options to hedge a contingent CF 8 Notation: 9 Basic principles of fx option pricing 9 Simple relationships 9 7. Put-call parity relationship for fx options 10 Introduction I am not sure how many of you have studied options before and in what detail. They are very interesting securities, different from all the other financial securities we have seen so far for they allow for a non-linear (kinked) pattern of returns. Also they are are very simple to understand - especially since you have all seen options in real life. Let us try and remind ourselves about these examples. Definitions A call option is a right to buy the underlying security (in our case the fx) for a fixed price (strike or exercise price) on or before a certain date (maturity date). A simple example of this is a rain-check. The normal logic will work if the price of the option is quoted as HC/FC. Otherwise, either convert the price, or think of the call on the HC as put on the FC, and vice-versa. Call options Example of Call option Suppose that you went shopping during a Xmas sale for a Sony camcorder, selling for $700 - a must have item in todays yuppie world and the store had run out of this item. Then the store might issue you with a rain-check which would permit you to got back to the store within a month and buy the camcorder for $700. Suppose the day you