Currency Options
A Currency option also referred as FX, or FOREX option is a financial product known as derivative where the value is established off an fundamental instrument, which in this case is a foreign currency. FX alternatives are call or put alternatives that give the buyer the right to buy or sell a currency pair at the be in agreement with strike price on the stated expiration date.
FOREX option trading was initially conducted only by large institutions where portfolio managers , corporate treasurers and fund managers would offload risk by hedging their currency exposure in the FX option market. However, currency choices are now very popular amounts retail investors as electronic trading and market access is now available in wide variety.
When currency alternatives first came on the scene, they were indeed traded OTC where organization and broker or dealers trade with each other over the phone to hedge their foreign currency exposure. With institutions dealing with transactions in the billions, this makes sense, especially since, unlike futures/stocks /options, there is no central trading emplacement for foreign exchange.
However, many retail online brokerage firms as well as larger institutions render electronic access to FOREX liquidity pools that also include the trading of currency alternatives online. Many of the alternatives traded by way of these firms are still believed OTC as the trader (customer) transacts directly with the broker, rather than matching the order with another trader. In such case the agent becomes the counter party to the currency option and therefore has to bear the risk.
This also means that currency alternatives can be catered to the individual trader. Without a standardized set of conventions dictated by an exchange, a trader can select the strike/expiry and in rare case the expiration style of the contract that is traded with the broker.
Not all electronic trading destinations for currency alternatives are OTC though. There are firms that render liquidity pools for institutions to transact with one another often called Dark Pools. For instance, Hot Spott, FXAll and CurrenX are all liquidity destinations for the FOREX market.
Along with the FOREX liquidity pools and OTC with broker, currency alternatives are also traded on exchanges. For instance, the PHLX (NASDAQ) and the CME both offer currency alternatives on currency futures. These products will also be approachable by most retail online FX option brokers.
For currency alternatives that are OTC with your broker/dealer, you have what's known as counterpart risk. That is, the risk that the business firm that adjudges the other side of the transaction goes bankrupt, along with any financial obligation to bear foreign currency. Any option be in agreements that you as a trader/client hold with such a company become worthless. Counter-party risk is more present in currency alternatives than stock or futures alternatives since there is no central clearing house to protect option traders when the dealer is not able to meet the work obligations.
In terms of market risk, FX alternatives are more sensitive to macroeconomic components than stock or futures options. Political and/or economic components play a large role on the view of currencies. Stock alternatives on the other hand, while still influenced by macro economic conditions, are also determined by company specific variables such as net income studies, sector sentiment, downgrades etc.
Currency Option Valuation
FX alternatives are in general European and hence can employ a standard B&S model. Like an equity option, currency alternatives can be priced using a standard black and scholes option model with a dividend yield. With a currency option, the dividend yield makes up the foreign currency's continually compounded risk-free interest rate. In the same way, FOREX option pricing will require to consider:
fundamental Price (the Spot FOREX rate)
Interest Rate = Local Currency Interest Rate
Dividend Yield = Foreign Currency Interest Rate
Strike Price = The cross rate at which the currency will be ex altered
Expiration Date = The expiry date of the option
Volatility = The anticipated future volatility of the exchange rate over the life of the option
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