Foreign-exchange Option - Terms

Terms

  • Call option – the right to buy an asset at a fixed date and price.
  • Put option – the right to sell an asset a fixed date and price.
  • Foreign exchange option – the right to sell money in one currency and buy money in another currency at a fixed time and relative price.
  • Strike price – the asset price at which the investor can exercise an option.
  • Spot price – the price of the asset at the time of the trade.
  • Forward price – the price of the asset for delivery at a future time.
  • Notional – the amount of each currency that the option allows the investor to sell or buy.
  • Ratio of notionals – the strike, not the current spot or forward.
  • Non-linear payoff – the payoff for a straightforward FX option is linear in the underlying currency, denominating the payout in a given numéraire.
  • Numéraire – the currency in which an asset is valued.
  • Change of numéraire – the implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of .

The difference between FX options and traditional options is that in the latter case the trade is to give an amount of money and receive the right to buy or sell a commodity, stock or other non-money asset. In FX options, the asset in question is also money, denominated in another currency.

For example, a call option on oil allows the investor to buy oil at a given price and date. The investor on the other side of the trade is in effect selling a put option on the currency.

To eliminate residual risk, match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don't offset.

In the case of an FX option on a rate, as in the above example, an option on GBPUSD gives a USD value that is linear in GBPUSD using USD as the numéraire (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 / $2.0000 = $100,000 profit), but has a non-linear GBP value. Conversely, the GBP value is linear in the USDGBP rate, while the USD value is non-linear. This is because inverting a rate has the effect of, which is non-linear.

Read more about this topic:  Foreign-exchange Option

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