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FOREIGN EXCHANGE OPTIONS


Contents

Introduction

Foreign Exchange Options Expertise

What Are Foreign Exchange Options?

Pricing Options

Exotic Options

Structured Currency Products

Case Studies - Hedging

Case Studies - Trading

Case Studies - Investments

Summary


Introduction

The currency turmoil seen in recent years, together with increasingly global and competitive markets, have added to the difficulties faced by the corporate hedger and institutional investor in managing foreign exchange risk. With multinational companies exposed through offshore plants and/or overseas sourcing and sales, and investors exposed to currency risk through cross border investments, demand for effective risk management instruments has grown dramatically.

Companies and institutions have found that currency options offer them possibilities to capitalise on favourable exchange rate movements while providing protection from adverse movements. With competitors equally able to neutralise risk without sacrificing the opportunities to be found in favourable markets, today's risk managers are finding that the advantages of currency options cannot be ignored.

Risk managers who hedge with options range from the simplest one person treasury to the “ultra-sophisticated” profit orientated trading room. All realise that the foreign exchange market can be too volatile to remain exposed, and yet business may be too competitive to sacrifice opportunity.

Genesis’s Foreign Exchange Options Group responds to this need. A world-class provider of risk management expertise, Genesis holds a prominent position in the global foreign exchange markets.

Our worldwide network includes principal trading desks in Asia, the US and Europe, putting us at the forefront of foreign exchange markets 24 hours a day. Genesis provides foreign exchange services to a broad range of customers and trades virtually all currencies.

In the currency options markets, Genesis is a recognised leader. We design option strategies and products to meet clients’ individual needs, giving flexibility and competitive pricing, and ensuring that clients receive the level of hedging they require. Our aim is to be the world’s number one risk management provider.

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Foreign Exchange Options Expertise

Genesis’s Foreign Exchange Options Group ranks in the top tier among OTC (over-the-counter) and exchange traded FX option market-makers, trading options in all the major currencies and most of the liquid exotic currencies. Genesis’s presence in the major trading centres in the US, Europe and Asia allows us to provide a 24-hour service to our global client base. These resources, plus Genesis’s investment in the option product, enable us to provide excellent pricing and risk management service across a diverse range of currencies and products for our clients.

Flexibility

The key advantage of using options for hedging, trading or investment purposes, is the flexibility they provide. Options allow their users to put a value on risk, an important aid in the process of making decisions on risk portfolio management.

Flexibility is also a feature of the service provided by Genesis, both in terms of currency pairs available and option maturities. Portfolios in excess of 70 currency pairs are traded by Genesis’s Foreign Exchange Options Group, for maturities ranging from a single day to over 10 years (forward markets permitting). New and innovative exotic options products are constantly being developed, enabling Genesis to tailor option solutions to individual business or investment needs.

Understanding Risk

The basic principle of an option is a simple one. The holder has the right (but not the obligation) to transact and the writer has an obligation to transact should the holder wish to exercise its right. More complex option combinations and exotic options are based on these fundamental principles, and Genesis invests much time and effort in helping clients understand how options could address their needs in the risk management of their currency portfolio. The risk/reward implications of different option strategies are clearly explained to clients so that they can decide which is the most appropriate strategy for their purposes. Genesis’s Foreign Exchange Options Group has expanded its internal training programmes for FX marketing executives to ensure that clients aims and exposures can be best understood and serviced.

Solutions

In today’s environment, individual risk appetites, market views and hedging objectives differ greatly. At the same time, there is a vast array of option structures and exotic option products available which could be applied to risk portfolios. In order for options to be integrated effectively into a customer’s FX strategy, Genesis’s Foreign Exchange Options Group works with each one to suggest appropriate structures, in keeping with the client’s expectations, cost and risk mitigation priorities. After consideration of the alternatives, the option solution most appropriate to the specific set of objectives, appetites and views can be selected by the customer.

Genesis’s service extends beyond inception of the deal, helping customers adjust their hedge positions in the light of changing market conditions.

Emerging Market Currencies

As the global markets expand, so does the demand for hedging tools in the more exotic currencies, and Genesis spares no effort to provide versatile solutions for clients with exposure in the less liquid markets. As one of the most active market makers in exotic currency spot and forward markets, we are well placed to achieve effective option hedges, where possible, for those clients investing in or trading with the relevant countries.

Summary

Genesis provides a wide range of foreign exchange option services in its partnership with its clients: flexibility both in maturities and currency pairs quoted; knowledgeable and focused assistance in defining and analysing risk; and innovative solutions designed to fit clients’ individual situations.

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What are Foreign Exchange Options?

A standard option gives the holder the right, but not the obligation, to buy a specified amount of one currency for another at a specific rate on or before a specific date. The buyer of the option pays an up front premium for that right.

A Call allows the holder to buy the currency, whereas a Put allows the holder to sell the currency. In the foreign exchange markets though, as every transaction involves the purchase of one currency and the sale of another, a Call on one currency will by definition be a Put on the other currency of the pair. If the holder of the option decides to take up the right to buy (sell) the currency specified in the option, he is said to exercise the option and the option contract becomes a simple FX contract. The holder of the option willingly exercises when the market is favourable for him to do so, otherwise he will allow the option to lapse and expire worthless.

The currency options market began as an exchange-traded market: in December 1982, the Philadelphia Stock Exchange launched its first FX options contract on sterling against the US dollar. Since then, the OTC market - options traded between counterparties - has grown to be much larger than the exchange-traded market. Currency options are now actively traded in a wide range of currency pairs across a diversity of maturities.

The principal difference between exchange-traded options and OTC options is that the former are typically available in a limited number of currencies, strike prices, and maturities; OTC options, because they are subject to negotiations between buyer and seller, can include any mutually agreed terms. Exchange-traded options carry very little risk of counterparty default, while OTC options are executed on the basis of lines of credit to the counterparty.

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Pricing Options

The holder of an option has the right but not the obligation to execute a specific FX transaction in the future. The ultimate value of that right depends on where the spot market is trading in the future.

Since the future is unknown, one must make an educated guess about where the spot market might be in order to determine the value of that right today. This is what option pricing theory is all about. Rather than trying to predict the future spot rate, however, option pricing takes a systematic, mathematical approach to the educated guess.

The calculation relies heavily on probability theory. The principal concepts are expected value and the lognormal distribution.

Expected value (E.V.) is the payoff of an event multiplied by the probability of it occurring. For example, the probability of rolling a six on one die is 1/6, or 16.67%. The E.V. of a game in which one is paid $100 for rolling a six and nothing for any other roll is

(1/6 x $100) + (5/6 x $0) = $16.67

The expected value is the fair price for playing such a game.

An option’s premium can be thought of in the same way, although instead of six possible outcomes, there are hundreds: all the spot rates that might prevail at the option’s expiration. Each outcome will have specific value. This will be either zero, if the option is out-of-the-money at expiry, or the difference between the closing spot and the strike price if the option is in-the-money. Each closing spot rate can also be thought of as having its own probability. If, for each outcome, one multiplied the value of that outcome by its probability, and then added up the results, the sum would be the premium of the option.

The expected value of an option, the probability-weighted sum of all its possible payoffs, is its fair price.

The probabilities associated with rolling one die are easy to calculate. To calculate the probabilities associated with spot rates occurring some time in the future, option pricing models use a lognormal distribution curve.

A lognormal distribution describes the likelihood that the market will vary from current levels by the end of a given time period. It operates under two critical assumptions:

a) that the market moves in a random walk - a move up by 1% has the same probability as a move down by the same degree;

b) that the mean of the distribution, and therefore the most probable market price at the end of the period, is today’s current market rate. In foreign exchange options, that means the forward outright rate associated with the time period.

Other things being equal, a large distribution will result in a large option price. This is because it will encompass large positive returns (extremely in-the-money outcomes); these are not offset by equally large negative returns, since an option cannot be worth less than zero. A small distribution will generate a low option value because only modest positive returns fall within the realms of probability.

What then determines the size of a distribution curve? Market prices cannot move unless there is time in which to travel; nor can they move unless there is some degree of motion in rates, or volatility. It is in defining the likely range of future spot prices and their relative probabilities, that time and volatility play their essential role in option pricing.

The distribution curve applicable to a given option is constantly changing. Time inexorably passes, which inevitably shrinks the range around current levels that the market might exhibit at expiry (this is how time decay affects an option price). In addition, the volatility component of the calculation is constantly changing — this is an estimate made by option traders about future behaviour of the spot market  — and effectively when they buy and sell options they are ‘trading volatility’. An option premium is also affected by the location of the distribution curve relative to the option’s strike price.

For an option where the forward outright is equal to the strike price (at-the-money), half of the possible outcomes will be positive and half will be zero (this results from the random walk assumption). As the market moves, so the option is in-the-money, a larger number of the possible outcomes will be positive, and some highly positive outcomes become possible, so the expected value of the option will rise. Conversely, if the option moves out-of-the-money, relatively few of the possible outcomes will be positive returns, and more will be zero; this will cause the value of the option to decline.

The expected value of an option, then, is a function of two main elements: the size of the applicable distribution, which is a product of the time remaining before expiry, and the volatility expected during that time; and the location of the distribution versus the option's strike price, which is determined by the relationship between the strike and the current forward outright. The former establishes the range of possible outcomes and their probabilities, while the latter defines the pay-off value of each outcome.

A final element in option pricing that should be mentioned is the discount factor. An option’s pay-off will be realised upon exercise; the premium is payable at the outset. If the premium is to be equal to the expected value of the pay-off, it must be adjusted for the time value of money; the future number is discounted so that the present value of the premium is equal to the present value of the pay-off. This makes option premiums moderately susceptible to changes in interest rates (apart from the effect that interest rate changes have on forward outright rates).

The full description, then, is that an option premium equals the probability-weighted sum of all its possible pay-offs at expiry, discounted to the present. Option pricing models such as the famous Black-Scholes model use formula to calculate the expected value of an option based on these factors.

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Exotic Options

Exotic options are defined as such when their pay-off profile differs from that of a standard currency option. The most commonly used exotic options are described below.

Path-Dependent Options

An option whose pay-off depends upon the path that the spot rate travels over the lifetime of the option between inception and expiry.

Barrier Options

The largest and most actively traded group of exotic options. Barrier options are activated (knocked-in) and become exerciseable or are terminated (knocked-out) and cease to be exerciseable if a specific trigger level is reached before or on the expiry date. As the barrier option will not necessarily exist for the full maturity period of the option or may never be activated, barrier options command a lower premium than conventional or ‘vanilla’ options. There are two main types of barrier options, namely:

Standard Knock-Out and Knock-In Options

The option is activated (knocked-in) and becomes capable of exercise or terminated (knocked-out) and becomes incapable of exercise as the option is moving out-of-the-money. In this case the barrier level would be below the spot rate for a Call and above the spot rate for a Put. For these options, the premium reduction is a function of the trigger level. The more likely the option contract is to be knocked-out or the less likely it is to be knocked-in, the greater the premium reduction and vice versa.

Reverse Knock-Out and Knock-In Options

The option is activated (knocked-in) and becomes capable of exercise or terminated (knocked-out) and becomes incapable of exercise as the option is moving further into-the-money. In this case the barrier level would be above the spot rate for a Call and below the spot rate for a Put. Due to the quite different features of the reverse barriers versus the standard barriers, the former are priced and behave quite differently from the latter.

Average Options

The pricing of the option depends on an averaging process and there are two distinct types:

Average Rate Options

The option is cash settled at expiry by comparing the strike price with the average of a pre-determined series of spot rates, observed over the lifetime of the option. There is an associated premium saving over the standard or ‘vanilla’ option as the averaging process smoothes out the spot movements, thereby reducing volatility and hence the premium of the option.

Average Strike Option

The option differs from the Average Rate Option in that the strike price is not set until the expiry date. It is then set to equal the average of a pre-determined series of spot rates observed over the lifetime of the option. The Average Strike Option is then exercised against the spot rate prevailing at expiry and can be either cash or physically settled.

Look-Back Options

The option allows the holder to ‘look back’ over the lifetime of the option and transact at the most favourable exchange rate that has occurred during that time. There are two distinct types:

Optimal Rate Lookback Option

The strike is fixed on the initial deal date, and at expiry the option will pay out against the highest (for a Call) or lowest (for a Put), spot fixing rate over the option’s lifetime, regardless of the spot rate prevailing at expiry. The option is usually cash settled. As the option has the potential for a larger pay-off than the standard vanilla option, the option premium will be greater than that of the equivalent vanilla option.

Optimal Strike Lookback Option

This differs from the Optimal Rate Lookback in that the strike price is not fixed until the expiry date of the option. The strike is then fixed as the high (for a Put) or the low (for a Call) of the spot rate over the option’s lifetime. The option is then either cash or physically settled against the spot rate prevailing at expiry.

Digital (Binary) Options

An option whose pay-out is discontinuous. A premium is payable at inception; then, if certain conditions are satisfied, the pay-out will be a fixed, pre-determined amount of money. Once the pre-determined conditions have been satisfied, the pay-out remains fixed, regardless of where the underlying currency subsequently trades. If the conditions are not satisfied, then the option pays out nothing.

At-Maturity Digitals (European Digitals)

A Digital Option that pays out a fixed amount if the spot trades above (or below) a certain level at expiry, and pays nothing if spot does not trade above (or below) that level at expiry.

One-Touch Digitals (American Digitals)

A Digital Option that pays out a fixed amount if the spot rate trades above (or below) a certain level at any time up to and including the expiry date. The pre-determined pay-out amount can be payable either at that time, or at expiry, depending on the terms of the option when it was entered into.

The conditions that will determine a digital option’s pay-out may be of several types: a spot rate trading (or not trading), a range maintained (or broken), a level trading only after another level trades, and many more.

Correlation Dependent Options

An option whose pay-off depends on the correlation between two or more currencies or asset classes.

Basket Options

An option whose pay-off is related to the performance of a basket of currencies. Typically, the option will have a single Call (Put) currency and a basket of Put (Call) currencies. The proportions of these currencies will be specified in advance to suit the client's individual needs.

At maturity, the option’s value is determined by calculating the basket spot rate and comparing that with the strike price. The option can be either cash or physically settled. The premium reduction depends on the number of currencies and the composition of the basket involved, and the correlations between the constituent currencies of the basket and the Call (Put) currency.

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Structured Currency Products

Structured currency products are combinations of vanilla and exotic options, and use “building blocks” to create payoffs to suit the customer’s specific needs and views on the market. Some of the most commonly used structures are listed below.

Trigger Forward

The Trigger Forward structure is primarily designed for trading purposes, although it can be used as an alternative ‘hedge’ for a cash position as well. It is a zero cost structure, whereby the purchaser enters into a synthetic forward contract at a rate significantly more attractive than the prevailing market rate, but whereby the whole structure knocks out if a pre-determined trigger level (set in-the-money in relation to the forward rate) is reached at any time before the expiry of the structure.

The product could be of interest to those looking for a limited move on the underlying in their favour, and who think that the knock-out level is unlikely to trade.

It should be noted that the contract is a synthetic forward contract, and therefore one would be obliged to buy (sell) the underlying if the market were to trade unfavourably. The potential benefit to a hedger is that one is able to cover the exposure at a more favourable rate than the current forward; if however, the trigger level is reached, the hedge ceases to exist, leaving the exposure unhedged in an unfavourable market.

Forward Extra

The Forward Extra structure has been developed primarily for hedging purposes, and is essentially a vanilla option that becomes a synthetic forward contract if a trigger level (set out-of-the-money in relation to the forward rate) is reached at any time before the option expiry.

For zero cost, the purchaser of the structure acquires protection for any adverse exchange rate move - albeit at a rate somewhat worse than the forward outright - and can benefit from a favourable but limited move on the underlying (provided that the trigger level is not hit).

If the trigger level is reached, then the hedger would be obliged to transact at the unfavourable synthetic forward rate. The product has proved to be a popular alternative hedging tool, because it provides protection whilst offering the potential to outperform considerably the prevailing forward outright rate for zero cost.

Weekly Reset Forward

The Weekly Reset Forward structure has been developed for both trading and hedging purposes. It is a synthetic forward, where each portion of the contract needs to be activated on a weekly basis. For each week that the pre-established ‘fixing’ condition is satisfied, a portion of the contract is locked in.

If none of the weekly conditions is satisfied, then none of the contract is activated. If all the weekly conditions are satisfied, then the currency is bought (sold) at a more favourable outright rate than the initial prevailing market rate. The product is an interesting alternative for those with cash flows spread over a period of time, or for balance sheet hedgers.

It provides an opportunity to deal at a rate significantly better than the forward outright, but only for a portion of the amount corresponding to the frequency that spot has fixed above (below) a pre-determined trigger level.

Mini-Premium Option

The Mini-Premium Option structure has been developed mainly for hedging purposes. It is a structure for which no initial premium is paid; if, subsequently, pre-determined spot levels are traded, certain fixed premiums will be payable by the option holder at the maturity of the option.

The product offers a potentially zero cost structure for hedgers, but if all the trigger levels are traded, the customer pays a higher premium than the equivalent vanilla option.

However, for these trigger levels to have traded, the spot would have moved in favour of the hedger’s underlying position.

Range Binary

The Range Binary structure has been developed primarily for trading purposes and will profit if the spot rate stays within a range. A currency range is specified by the customer over a fixed period.

A premium is paid up front and provided that the spot stays within the range (as monitored on a 24-hour basis), then a multiple of the premium paid will be payable to the holder. If, however, either limit of the range is traded before expiry, then no pay-out will be due and the premium is forfeited. The product can be used on its own as a currency play for range-trading markets or combined with a deposit as a yield enhancement structure.

Wall Option

The Wall Option structure has been developed primarily for trading purposes. It profits to the extent a spot rate stays below (above) a certain pre-determined level. The customer specifies a currency rate, and pays a premium up front.

For every day during a set period that the spot fixes above (below) the specified rate, a portion of the pay-out is locked-in. If spot fixes below (above) the trigger level every day, then the maximum pay-out will be due; if none of the days satisfies the required condition, then no pay-out will be due. The product can be used on its own as a currency play for a customer with a view on the market’s direction, or like the corridor and range binary options, combined with a deposit for a potential yield - enhancement structure.

Corridor Option

The Corridor Option structure has been designed primarily for trading purposes. It profits to the extent that spot stays within a range and is often linked with a deposit for yield - enhancement purposes. The customer specifies a currency range, and pays a premium up front. For every day during a set period that the spot fixes within the specified range, a portion of the pay-out is locked in.

If spot fixes within the range every day, then the maximum pay-out will be due; if not a single day fixes within the range then the pay-out will be zero. The actual pay-out is calculated on a pro-rata basis. The product is similar to the range binary in that both will profit if a spot rate stays within a range. The difference is that, whereas the range binary structure is terminated if either of the boundaries trade at any time, the corridor option structure exists for the whole maturity period, with only the pay-out for that day forfeited should spot trade outside the range. As the corridor option has a less aggressive risk profile, its maximum pay-out will be smaller than for the equivalent range binary.

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