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5 November 2010
FX Derivatives
Arindam SandilyaAC
(1-212) 834-2304
arindam.x.sandilya@jpmorgan.com
Matthias Bouquet
(44-20) 7777-5276
matthias.bouquet@jpmorgan.com
Agenda
Basics of options 3
Volatility 26
OPTION TERMINOLOGY
USER INPUTS
INTRODUCTION TO FX OPTIONS
INTRODUCTION TO FX OPTIONS
80 0 0
85 0 0
90 0 0
95 0 0
F O R E I G N
100 0 0
105 5 0.0476
110 10 0.0909
115 15 0.1304
T O
K
120 20 0.1667
I N T R O D U C TI O N
125 25 0.2000
130 30 0.2308
135 35 0.2857
Out of the money In the money
At the money
4
INTRODUCTION TO FX OPTIONS
80 20 0.2500
85 15 0.1765
90 10 0.1111
95 5 0.0526
F O R E I G N
100 0 0
105 0 0
110 0 0
115 0 0
T O
K
120 0 0
I N T R O D U C TI O N
125 0 0
130 0 0
135 0 0
In the money Out of the money
At the money
5
INTRODUCTION TO FX OPTIONS
Buy Option in $ 10MM : Premium = $ 417,000 JPY per USD = 4.19% x 90 = 3.7710
Buy Option in 900MM : Premium = 37,710,000 or 377 JPY pips per USD
Buy Option in $ 10MM : Premium = 37,710,000 X 1 X So X 1 X SoK
S0 K S0
Buy Option in 900MM : Premium = $ 417,000 NC pips %AC % NC AC pips NC pips
6
INTRODUCTION TO FX OPTIONS
Prior to expiration, call options trade at prices higher than their in-the-moneyness, also referred to as their
intrinsic value.
- Intrinsic value of an in-the-money call = S K
- Intrinsic value of an in-the-money put = K S
- Intrinsic value of out of the money options = 0
OP TI O N S
The difference between the option value and the intrinsic value is the time value of the option. Time value
represents the additional value of an option due to the opportunity for the intrinsic value of the option to
increase. Mathematically, Option Value = Intrinsic value + Time value
E XC H AN G E
F O R E I G N
?
T O
TIME VALUE
I N T R O D U C TI O N
INTRINSIC VALUE
K
7
INTRODUCTION TO FX OPTIONS
money at expiry.
p
Strike
Ans.
Convert 1.0% EUR to USD per EUR P
= 1 * 1.45/1.50 =0.97%
P
2) USD per EUR = % USD * Strike
I N T R O D U C TI O N
P
= 0.97%*1.50 = 0.0145
Breakeven spot rate Spot rate at
maturity
Spot rate
at maturity
= Strike + Premium
Strike Strike
= 1.50 + 0.0145 = 1.5145
8
INTRODUCTION TO FX OPTIONS
- rfT - rdT
One can replicate any of (put, call, forward)
CP=Se - Ke
using the other two instruments
T O
(rd rf)T
or, given that F = S e ATMF calls and puts have the same price
I N T R O D U C TI O N
9
INTRODUCTION TO FX OPTIONS
10
INTRODUCTION TO FX OPTIONS
BASIC OPTION STRATEGIES CASE : CALL/ PUT SPREADS FOR TRADING CARRY
In general, carry in a trade refers to the P/L that can Trading carry using USD/BRL forwards vs. options
Short USD/BRL forwards at 1.7603
potentially accrue to the investor if market conditions
were to remain unchanged over the trade horizon.
In FX, carry trading refers to a strategy of buying high
yielding currencies and selling low yielding currencies,
via forward transactions. Since FX forwards are a
function only of spot and the two interest rates in
OP TI O N S
rate gains.
Consider USD/BRL as an example:
Spot (S) = 1.75 | r
BRL,1M = 7.38% | rUSD,1M = 0.30%
Forward (F) = 1.75* [1+ 7.38% * (1/12)]/[1+0.30%*(1/12)]
F O R E I G N
= 1.7603
The carry trade is to sell 1M USD/BRL forwards at 1.7603 Historical performance of forwards vs. options
All options and forwards are 1M in tenor, and rolled into fresh instruments
at the expiry of the previous one. No transaction costs. Unit notional/leg on
The alternative to trading carry through forwards is to use the put spread, forward notional sized so that 2-sigma monthly loss is equal
to the put spread premium
options. The optionalized version of the carry trade in this
T O
11
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Volatility 26
1
INTRODUCTION TO FX OPTIONS
Periods to expiration = 1
E XC H AN G E
13
INTRODUCTION TO FX OPTIONS
Today Expiration
S = 120
S = 80
E XC H AN G E
Today Expiration
S = 120
c = 20
T O
Strike = 100
I N T R O D U C TI O N
S = 100
S = 80
c= 0
14
INTRODUCTION TO FX OPTIONS
1 1
x [call value with S = 120] + 2 x [call value with S = 80]
2
OP TI O N S
1 1
= x [20] + x [0]
2 2
E XC H AN G E
= 10
Most options require the buyer to pay an up-front premium. On the other hand, the payoff to the option is
not received until some time in the future. The price of the option should therefore reflect the present
value of the expected payoffs. With a one period interest rate of 1%, the present value is:
T O
10
9.90 =
I N T R O D U C TI O N
(1 + 0.01)
15
INTRODUCTION TO FX OPTIONS
7 3
x [call value with S = 120] + 10 x [call value with S = 80]
10
OP TI O N S
7 3
= x [20] + x [0]
10 10
E XC H AN G E
= 14
14
13.86 =
(1 + 0.01)
T O
I N T R O D U C TI O N
DOES THE PRICE OF THE OPTION DEPEND ON SUBJECTIVE READING OF MARKET PROBABILITIES?
16
INTRODUCTION TO FX OPTIONS
Today Expiration
S = 140
OP TI O N S
S = 60
1 1 1
Your option price = X x 40 + x 0 = 19.8
F O R E I G N
1.01 2 2
1 7 3
Your friends option price = X x 40 + x 0 = 27.7
T O
1.01 10 10
I N T R O D U C TI O N
AT LEAST YOU AGREE ON THE FACT THAT RISING PRICE VARIABILITY LEADS TO HIGHER OPTION PRICES
17
INTRODUCTION TO FX OPTIONS
As a trader, assume you are short a call. How would you structure a trade such that you are perfectly
hedged in both the up and down scenarios?
$100
$80 $0 0 + 80 * x
F O R E I G N
To be perfectly hedged,
T O
-20 + 120 * x = 0 + 80 * x, or x = 0.50. i.e. buy 1/2 a share of stock to hedge yourself
I N T R O D U C TI O N
In both up and down scenarios, portfolio payoff = -20 + 0.5*120 = 0.5*80 = $40
The short call + 0.5*long stock portfolio is thus riskless, assured of a $40 value irrespective of the
state of the world
18
INTRODUCTION TO FX OPTIONS
Thus, the PV of future cash flows of the riskless portfolio has to equal the price at which the portfolio is
trading today
OP TI O N S
Thus, c = $10.39
19
INTRODUCTION TO FX OPTIONS
RISK-NEUTRAL PROBABILITIES
Although no probabilities are required for pricing options, risk-neutral probabilities may be estimated
A risk-neutral world is one where investors care only about expected returns, not the risk associated
with earning it
expected return from the call option is also the risk free rate
Let
E XC H AN G E
p = probability of an up move
q = 1-p = probability of a down move
Since the call also earns the riskless rate of return, its value is now the discounted value of the expected
payoff
call premium = (0.525 * $20 + 0.475 * 0) / 1.01 = $10.39
T O
I N T R O D U C TI O N
Risk-neutral probabilities are a mathematical trick that provides an intuitive way to price options. Our
intuitive valuation of options as the discounted value of expected payoffs is true when using so-
called risk-neutral probabilities
20
INTRODUCTION TO FX OPTIONS
The Black Scholes (BS) model of option pricing used Risk-neutral option pricing in a two-state world
a no-arbitrage replicating portfolio argument similar Payout
ST
S1 K S2
probability distribution of spot at maturity, ST, is
lognormal. This means that log (ST) is normally
max(S1 - K, 0) = 0 max(S2 - K, 0) = S2 - K
distributed.
E XC H AN G E
p1
e-r(T-t) [0*p1+ (S2-K)*p2] p2
21
INTRODUCTION TO FX OPTIONS
Note
22
INTRODUCTION TO FX OPTIONS
K1 K2 K3 K4
T O
I N T R O D U C TI O N
23
INTRODUCTION TO FX OPTIONS
There are six factors that affect the value of an option. The chart below is a handy way of referencing them.
+ -
OP TI O N S
Underlying Price
Strike - +
E XC H AN G E
Volatility + +
F O R E I G N
24
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Volatility 26
2
INTRODUCTION TO FX OPTIONS
MEASURING VOLATILITY
Volatility is a measure of the variability of prices or Volatility is the dispersion of the spot return distribution
yields.
15%
100 0%
I N T R O D U C TI O N
-20%
26
INTRODUCTION TO FX OPTIONS
Step 1: Collect closing prices Step 2: Calculate daily returns (percent changes)
P1 = 99.48
R = P 2
P1
=
99 . 73 99 . 48
=
0 . 25
= 0 . 0025 (0.25%)
P2 = 99.73
2
P 1
99 . 48 99 . 48
P3 = 99.00
R = P 3
P2
=
99 . 00 99 . 73
=
0 . 73
= 0 . 0073 (-0.73%)
P4 = 98.00
3
P 2
99 . 73 99 . 73
OP TI O N S
R = P 4
P3
=
98 . 00 99 . 00
=
1 .0
= 0 . 010 (-1.0%)
4
P 3
99 . 00 99 . 0
Step 3: Calculate a standard deviation of daily returns Step 4:Convert daily volatility to annual volatility
E XC H AN G E
27
INTRODUCTION TO FX OPTIONS
N days
N
1 S i
= * ln
N i = 1 S i-1
For the entire sequence of N returns observed above, the expression for
sample RMS variance is shown below. Note that this is the square of the RMS
Notes
volatility
The first thing to realize about realized volatility is that it is NOT a known
quantity, just a MEASURE. The true volatility of any underlying can, and often [
RMS variance, N2 = r12 + r22 + r32 + ....rN2 / N ( A ) ]
E XC H AN G E
[ ]
consistent with the P/L of a delta-hedged option (refer to the expression for net
P/L of a delta-hedged option earlier), and is more relevant for an option trader RMS variance, M2 = r12 + r22 + r32 + ....rM2 / M (B)
Mean-adjusted volatility differs from RMS volatility in that it de-trends spot RMS variance, N2-M = [
rM2 +1 + rM2 + 2 + rM2 + 3 ]
+ ....rN2 /( N M ) (C )
F O R E I G N
returns, and captures the noise around the mean. It is more relevant for
market observers seeking to simply quantify the uncertainty or noise around spot Equations (A), (B) and (C) yields:
trends.
M M2 + ( N M ) N2- M
Clearly, RMS and mean-adjusted measures of realized volatility will be equal N2 =
when m = 0 i.e. spot observations display no trend, but can differ significantly N
T O
102 The core assumption of annualization is that any observed sample of returns will repeat
115
its pattern over the remainder of the year (approx. 252 trading days)
101
110 The variance of any sample of daily returns can be annualized by multiplying by 252
100
105 The volatility of any sample of daily returns can be annualized by multiplying by 252
RMS vol = 22.8% 99 RMS vol = 16.5%
Mean-adj. vol = 16.9% Mean-adj. vol = 16.9% The variance of any sample of weekly returns can be annualized by multiplying by 52
100 98
The volatility of any sample of weekly returns can be annualized by multiplying by 52
0 5 10 15 20 0 5 10 15 20
28
INTRODUCTION TO FX OPTIONS
HISTORICAL VOLATILITY IN FX
Realized FX volatility has seen high and low and in fact has been reasonably well correlated
regimes, like every other asset class. with equity volatility
OP TI O N S
E XC H AN G E
Realized vol in some currency pairs like USD/JPY and not so much in some others like EUR/USD
are strongly correlated to spot moves.
F O R E I G N
T O
I N T R O D U C TI O N
29
INTRODUCTION TO FX OPTIONS
IMPLIED VOLATILITY
the e o
2. But given spot, strike and interest rates, the elta lt of vo ption
s d l te r
p ti o n a re s u d rm olls
calculation of the delta of the option itself needs a o s an
The ges a f time d the str up
uc or
n
volatility input (remember Black Scholes formula for cha sage o pot an tur d
s e ow
pas es in n
v e
delta) i.e. vol cannot be known unless delta is known, mo urfac
s
vol 10
E XC H AN G E
butterflies for 10D and 25D strikes (called pillars) Implied vols are quoted in terms of ATMs, risk-
Risk-reversal (RR) = Call vol Put vol reversals and butterflies
30
INTRODUCTION TO FX OPTIONS
The normal term structure of vols is Strikes are quoted in terms of delta rather
upward sloping. than absolute spot values (sticky delta
rule)
High realized volatility, or anticipation
thereof, pushes all vols higher, with Some currencies exhibit a high degree of
front-end vols moving more than back- skew (e.g. AUD/USD, USD/JPY) while
end vols. This leads to inversion of the others have relatively lower skew (e.g.
OP TI O N S
Moves in vol curves are led by those In addition to spot-vol correlation, skews
in front-end vols. are often valued by comparing them to the
T O
essential to formulating a curve means that currency pairs with the highest
view. carry attract the most flows, and are
there-fore susceptible to the sharpest
If back-end vols are considered to be
unwinds. As a result, skews tend to be bid
the sum of front-end vols AND the vol
higher for carry currency puts in those
curve, a view on each of these
currency pairs.
quantities can be aggregated to form
a back-end vol view
31
INTRODUCTION TO FX OPTIONS
32
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Volatility 26
3
INTRODUCTION TO FX OPTIONS
p2*max(S2-K,0)].
max(S1 - K, 0) = 0 max(S2 - K, 0) = S2 - K
E XC H AN G E
= e r (T t ) (ST K ) (ST )dS T
T O
K
- r : continuously compounded discount rate
I N T R O D U C TI O N
34
INTRODUCTION TO FX OPTIONS
spaced strikes.
This is more involved than it first appears, because the
35
I N T R O D U C TI O N T O F O R E I G N E XC H AN G E OP TI O N S
36
INTRODUCTION TO FX OPTIONS
INTRODUCTION TO FX OPTIONS
* ATM2 = ln (M2/M12)
F O R E I G N
The skewness* of the implied distribution is highly The kurtosis* of the implied distribution is highly
correlated to risk-reversals (call vol put vol) correlated to butterflies
T O
I N T R O D U C TI O N
* Kurtosis = M4/M22
* Skewness = M3/M23/2
37
INTRODUCTION TO FX OPTIONS
NZD/USD AUD/USD
The study tests the efficacy of spot trading by applying a 20-day momentum rule to all
variables. The variables are spot itself, forwards, ATM vols, risk reversals and butterflies.
25D Risk Reversal (RR) = 25D Call Vol 25D Put Vol; 25D Butterfly (FLY) = 25D Call Vol + 25D
Put Vol 2* ATM Vol
T O
Trading rule: If variableT > = 20D moving average of the variable, buy spot, else sell spot
When the signal variable is spot itself, the trading rule becomes a simple technical / spot
momentum algorithm. In order to provide incremental tradeable intelligence, trading
I N T R O D U C TI O N
results based on option market data need to outperform those from spot momentum rules.
The spot momentum rule therefore becomes the control / anchor for this study
The upper number in % denotes annualized % return, the lower number denotes information
ratio:
annualized % return
IR
Returns shown in the table are purely FX returns i.e. they have no carry component
No transaction costs assumed
38
INTRODUCTION TO FX OPTIONS
NZD/USD
F O R E I G N
39
INTRODUCTION TO FX OPTIONS
Takeaways
As signals for directional trading the vol surface really matters for high Risk-reversals widely considered to be an indicator of positioning / risk
skew currency pairs, not as much for those with low skews sentiment (and therefore in theory crucial to the performance of high
Momentum in ATM vol has historically been a decent indicator for spot beta currencies) are overrated as spot trading indicators
For AUD and NZD, the term structure of ATM vols is a much more
OP TI O N S
40
INTRODUCTION TO FX OPTIONS
3
OP TI O N S
E XC H AN G E
F O R E I G N
4
T O
I N T R O D U C TI O N
41
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Volatility 26
4
INTRODUCTION TO FX OPTIONS
DELTA
Delta is the change in the price of an option for a 1 unit move in the underlying. A delta of 0.5 means that a
one cent increase in the underlying price will cause a one-half of a cent increase in the option price. Hence,
the option price moves only half as much as the underlying price.
Since delta is a measure of how sensitive an option's price is to changes in the underlying, it is useful as a hedge
ratio. An USD/JPY option with a delta of 0.5 means that the option price increases by roughly 1 USD pip for
every 2 pip increase in the USD/JPY spot rate. For small changes in the spot price therefore, the option
behaves like one-half of spot.
E XC H AN G E
Constructing a delta hedge for a long position in $100mn notional of ATM USD/JPY calls with a delta of 0.5
would require you to sell $50mn of USD/JPY spot. (The delta of spot is always 1.)
Moneyness
F O R E I G N
Delta can be interpreted as the probability that an option will end up in-the-money. An at-the-money option,
which has a delta of approximately 0.5, has roughly a 50/50 chance of ending up in-the-money. Out-of-the-
money options have deltas less than 0.5; in-the-money options have deltas greater than 0.5.
T O
Call option deltas range between 0 and 1. Put option deltas range between 0 and -1.
I N T R O D U C TI O N
The delta of a long option position increases as the underlying price increases. (This is true for both calls and
puts.) This reflects one of the main benefits of being long options compared to holding a position in the
underlying. A long option position becomes longer the market (delta increases) when the market is rallying and
shorter the market (delta decreases) when the market sells off.
43
INTRODUCTION TO FX OPTIONS
DELTA (CONTD)
Call Deltas 100 Call Option Premium (10% vol) Put Deltas 100 Put Option Premium (10% vol)
Price
Increase as the Price Increase as the
underlying underlying price 3.5
3.5 Delta=-0.85
price increases Delta=0.85 increases 3 1 month to expiration
3
Can be 0.76 Can be 2.5 -0.75
2.5 interpreted as
interpreted as 1 month to expiration 2
0.64 -0.63
the probability 2 -1 times the 1.5
probability that -0.49
that the 1.5
0.5 1 expiration -0.36
OP TI O N S
as time passes
0
0
97 98 99 100 101 102 103
I N T R O D U C TI O N
44
INTRODUCTION TO FX OPTIONS
DELTA (CONTD)
Time to expiration
Deltas of out-of the money call options decrease towards zero as time passes.
Volatility
An increase in volatility raises the delta of out-of-the-money call options, and lowers the delta of in-the-
E XC H AN G E
money call options. At higher volatility levels, out-of-the-money options have a greater chance of ending up
in-the-money; in-the-money options have a greater chance of ending up out-of-the-money.
A doubling of volatility has roughly the same effect on an option's delta (and its price) as a quadrupling of
time. For example, the 100 strike call option delta is 0.92 with 1 month to expiration, spot = 102, and
F O R E I G N
volatility = 5%. If volatility increases to 10%, the delta falls to 0.76, which is about the same delta that a 4-
month option would have with volatility at 5%.
T O
I N T R O D U C TI O N
45
INTRODUCTION TO FX OPTIONS
46
INTRODUCTION TO FX OPTIONS
GAMMA
Definition
An option's gamma is defined as the change in delta for a one unit change in the underlying price. Note that the unit
change in the underlying price may be defined differently depending on the option pricing model being used. In the
table above, it is defined as the change in delta for a one point move in the underlying; in Morgan Futures option pricing
software, it is defined as the change in delta for a .01 move in the underlying futures price (and then is multiplied by 100
to make the number easier to read).
The gamma of a long option position (both calls and puts) is always positive. This means that delta increases as the
OP TI O N S
underlying price increases and that delta falls as the underlying price falls.
Moneyness
ATM options have the largest gamma. The further an option goes in-the-money or out-of-the-money, the smaller is
E XC H AN G E
gamma.
Time to expiration
The gamma of in-the-money and out-of the money options will converge to zero at expiration.
Volatility
T O
An increase in volatility will lower the gamma of ATM options and raise the gamma of deep ITM and OTM options.
I N T R O D U C TI O N
A doubling of volatility has roughly the same effect on an option's gamma as a quadrupling of time. For example, the
gamma of the 100 strike call option is 0.42 with 1 week to expiration, futures = 100, and volatility = 5%. If volatility
increases to 10%, the gamma falls to 0.27, which is about the same gamma that a 1-month option would have with
volatility at 5%.
47
INTRODUCTION TO FX OPTIONS
GAMMA
Gamma is the 100 Call Option Premium (10% vol) ATM options have 100 Call Option Gammas (1 week)
change in delta the largest
for one unit gamma. 10% vol
Price
move in the Gamma
3.5 0.3 0.27
underlying. Delta=0.98
3
0.25
2.5
0.92 0.2
2 1week to expiration
OP TI O N S
1.5 0.15
0.77
1 0.5 expiration 0.1
0.5 0.24 0.05 0.06 0.06
0.07
0 0
97 98 99 100 101 102 103
E XC H AN G E
As time passes, 100 Call Option Gammas (10% vol) As volatility falls, 100 Call Option Gammas (1 month)
The gamma of The gamma of
F O R E I G N
Gamma Gamma
an ATM option an ATM option
0.3 0.3
increases 1 week increases 5% vol
0.25 0.25
The gamma of The gamma of
deep ITM and 0.2 deep ITM and 0.2
OTM options OTM options
0.15 0.15
T O
decreases decreases
0.1 1 month 0.1 10% vol
I N T R O D U C TI O N
0.05 0.05
0 0
97 98 99 100 101 102 103 97 98 99 100 101 102 103
48
INTRODUCTION TO FX OPTIONS
Definition
Theta is defined as the change in the price of an option for a 1-day decrease in the time remaining to
expiration.
OP TI O N S
Moneyness
ATM options have the greatest time value and the greatest rate of time decay (theta). The further an option
E XC H AN G E
Time to expiration
F O R E I G N
Volatility
T O
The time value of an option increases as volatility increases and so too does theta.
I N T R O D U C TI O N
49
INTRODUCTION TO FX OPTIONS
THETA (CONTD)
ATM Call Option Premium (10% vol) ATM options have 100 Call Option Thetas (1 week)
Theta is the
change in the the largest time
10% vol
value of an Premium value and the Theta (cents/day)
option with one Days to Expiration 120 30 7 largest theta.
2.5 4.5
days passage of Daily change in Premium 0.009 0.019 0.049 -4.09
4
time. 2 3.5
1.5 3
2.5
OP TI O N S
1 2
-0.19 -1.37
1.5 -1.28
0.5 10 days 1
0.5
0
0
120 90 60 30 0
E XC H AN G E
As time passes, 100 Call Option Thetas (10% vol) As volatility falls, 100 Call Option Thetas (1 week)
The theta of an ATMTheta (cents/day) Time value declines
option increases Theta (cents/day)
F O R E I G N
2 2
1.5 1 month 1.5
I N T R O D U C TI O N
1 1 5% vol
0.5 0.5
0 0
97 98 99 100 101 102 103 97 98 99 100 101 102 103
50
INTRODUCTION TO FX OPTIONS
VEGA
Definition
Vega is the change in the value of an option for a 1 percentage point increase in implied volatility. The
vega of a long option position (both calls and puts) is always positive.
OP TI O N S
Moneyness
ATM options have the greatest vega. The further an option goes in-the-money or out-of-the-money, the
smaller is vega.
E XC H AN G E
Time to expiration
Time amplifies the effect of volatility changes. As a result, vega is greater for long-dated options than for
F O R E I G N
Volatility
T O
An increase in volatility increases vega for in-the-money and out-of-the money options.
I N T R O D U C TI O N
A change in volatility has no effect on the vega of ATM options. This means that ATM option prices
increase linearly with changes in volatility.
51
INTRODUCTION TO FX OPTIONS
VEGA (CONTD)
Vega is the change in 100 Call Option Premium (1 month) ATM options have 100 Call Option Vega (1 month)
the price of an option the largest vega. 10% vol
for a one percentage Premium
Vega
point increase in 1.6 0.12
implied volatility. 1.4 1% F=100 0.11
1.2 0.114 0.1
1
OP TI O N S
0.09
0.8
0.08
0.6 F=98 0.07
0.4
0.06
0.2
0 0.05
0.04
E XC H AN G E
6 8 10 12 14
97 98 99 100 101 102 103
volatility
As time passes, ATM Call Option Vega (10% vol) As volatility falls, 100 Call Option Vega (1 month)
vega decreases
F O R E I G N
Vega Vega decreases for Vega
0.25
ITM and OTM 0.12
0.226 options 10 % vol
0.1
0.2 Vega is unchanged
for ATM options 0.08
0.15
T O
0.114 0.06
5% vol
0.1
I N T R O D U C TI O N
0.04
0.05
0.02
0 0
120 90 60 30 0 97 98 99 100 101 102 103
days to expiration
52
INTRODUCTION TO FX OPTIONS
Q. You are long a 6M 90 strike USD call/JPY put. Spot is Portfolio Gamma = N1* Gamma1 + N2*Gamma2
90.25. The option greeks are as follows: delta = 48, Portfolio Theta = N1* Theta1 + N2*Theta2
gamma = 5, theta = -2 bp/day, vega = 30bp. What is Portfolio Vega = N1* Vega1 + N2*Vega2
the change in price of the option if spot USD/JPY
F O R E I G N
rallied 1% over the next day, assuming that volatility Can you construct option portfolios that are:
of the option declined 0.4 percentage points as a Delta-neutral but long gamma?
result? Positive delta but neutral-gamma?
A. Change in spot = 1% = 100 bp Positive gamma but negative vega?
T O
Delta P/L = 0.48 * 100 = 48 bp Hint: Remember, Greeks can vary for different options
I N T R O D U C TI O N
Gamma P/L = (1/2) * (5) * (1)2 = 2.5 bp of the same tenor if their strikes are different, and for
Theta P/L = - 2 bp/day * 1 day = -2 bp options of the same strike if their tenors are different
Vega P/L = 30 * -0.4 = -12 bp If you were uncertain as to the direction in which spot
Net P/L = 36.5 bp would move, but guessed that spot moves would be large in
either direction, which of these three portfolios would you
favor?
53
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Volatility 26
5
INTRODUCTION TO FX OPTIONS
55
INTRODUCTION TO FX OPTIONS
56
INTRODUCTION TO FX OPTIONS
57
INTRODUCTION TO FX OPTIONS
1.50 1.30
1.45 AUDUSD/EURAUD 3M Implied Vol Spread 1.25 GLDUSD/GLDEUR 3M Implied Vol Spread
1.40 1.20
1.35 1.15
1.30 1.10
1.25
1.05
OP TI O N S
1.20
1.00
1.15
0.95
1.10
1.05 0.90
1.00 0.85
Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10
E XC H AN G E
The scatter chart plots rolling 3M returns for EUR/AUD against AUD/USD. The
isopremium line is constructed of (AUD/USD,EUR/AUD) strike pairs that yield
premium neutral option combinations, and represents the extent to which
EUR/AUD needs to move for a given AUD rally for the long/short option spread to
start losing money. Put differently, the isopremium line represents an option
implied beta between the two assets, which in this case seems to be significantly
F O R E I G N
58
INTRODUCTION TO FX OPTIONS
BARRIER OPTIONS
mn. In this case, Notional = $1mn/.01 (pip in Option Type USD put USD put USD put
T O
59
INTRODUCTION TO FX OPTIONS
AT-EXPIRY-DIGITALS
Spot
Quantity (USD, mm) 1 9,000 9,000
any increase in volatility will not increase the value Price(%) 15.25% 1.140% 1.3750%
of the option if USD/JPY continues downward, as the BS TV (%) 18.60%
Vega as we move in the direction where Vega is in USD/JPY (MM) (k) P/L (k) (k)
demand should mean the structure trades lower 16% 114.29 0 -159 -16 0 4
12% 109.09 0 -143 -26 0 5
relative to BS. Buying this Option from a dealer gives
8% 104.35 -1 -117 -45 0 7
him a risk position with properties he would pay a 4% 100 -1 -72 -72 -1 10
T O
market. By the Non-Arbitrage Principle, then, the fair -8% 88.89 -5 258 150 0 0
value of the Digital in this case, must be below BS -12% 85.71 -5 445 187 1 -17
-16% 82.76 -4 608 163 1 -24
Value.
60
INTRODUCTION TO FX OPTIONS
AT-EXPIRY-DIGITALS
The price discount to BS decreases in lower strikes. Lower-strike USD/JPY at-expiry-digital puts trade
at a lower premium to BS than higher strikes,
This is a function of how quickly the structures lose
since vega turns negative more quickly in higher
their Vega as spot moves lower. The higher-strike strikes
option becomes shorter vega more quickly as 95-strike digital put 91-strike digital put
USD/JPY sells off and therefore is priced at more of a Delta PNL Vega Delta
discount to BS than the 91-strike. USD/JPY (MM) (k) (k) (MM) PNL (k) Vega (k)
OP TI O N S
-4% 156 8
relative to a BS price), being short Vega where vols -8% 88.89 -4 474 -22 -7 386 -9
-12% 85.71 -2 573 -14 -5 620 -23
are less bid than ATM implieds (in our case, in -16% 82.76 -1 615 -8 -2 734 -15
USD/JPY upside strikes), then the structure will trade
at a premium to BS. One-Touches trade at less of a discount to BS than
F O R E I G N
do at-expiry-digitals
At Exp One Vega
Digital Touch At-Exp One-
Option Type USD put USD put USD/JPY Digital Touch
Strike 90 90.00
T O
61
INTRODUCTION TO FX OPTIONS
While At-Expiry Digitals pay out only upon expiry, One-Touches trade at twice the price of At-Expiry
One-Touches pay out as soon as the strike is Digitals
breached. Notice that One-Touch is almost exactly At Exp One
twice the cost of the At Expiry Digital. There should Digital Touch
Option Type USD put USD put
be some intuition in this: imagine an At-Expiry Digital Strike 90 90.00
Spot 96 96.00
right at the money -- its price should be near 50%.
Quantity (USD, mm) 1 1
OP TI O N S
The One-Touch with Spot on top of the barrier has Price(%) 15.25% 36.50%
BS TV (%) 18.60% 37.80%
paid, so its worth 100%.
do At-Expiry Digitals
however, they trade at less of a discount. The Vega
framework that we used before applies here as well. Vega
At-Exp One-
As with the At-Expiry Digital, the One-Touch loses USD/JPY Digital Touch
Vega as USD/JPY declines, hence the reason for the
F O R E I G N
8% 104.35 7 12
discount to BS. However, because the structure pays 4% 100 10 19
out once the strike is reached, the 0 vega no longer 0% 96 11 27
-4% 92.31 9 21
matters for those scenarios. As a result, there is less -8% 88.89 0 0
of a discount than in the At-Expiry Digital. -12% 85.71 -17 0
T O
62
INTRODUCTION TO FX OPTIONS
in, i.e. the 1250 strike that we have shorted does not knock in
Strike
until 1350. Because of the rich skew, we can buy the call
spread with RKI for only 8bp more than the vanilla call spread.
The structure with the RKI has much more upside potential
provided that spot remains below 1350. making call spreads with an RKI attractive
F O R E I G N
The call spreads with RKIs offer attractive upside 210 call spread
call spread w / RKI
for a relatively low increase in up-front cost, as contingent RKI P/L
we are selling a higher skew 160
max contingent
110
T O
spread 60
call spread
w/ RKI 6M 1145 1250 1350 3.71% 14.5% 5.7%
10
-40
1100 1150 1200 1250 1300 1350
Spot
63
INTRODUCTION TO FX OPTIONS
than buying calls outright, even though the right tail and 3M ATM / 25D call spreads in gold, contingent on gold rallies. Note that the call
spread RoI distribution has a higher mean than the outright call RoI distribution,
of the P/L distribution for the latter is obviously even though the right tail for the latter is obviously thicker. Data since Jan-06
thicker.
T O
64
FX Vol Trading 101.ppt
Agenda
Basics of options 3
Volatility 26
6
INTRODUCTION TO FX OPTIONS
volatility trading
21
Gamma Trading
Vega Trading
19
E XC H AN G E
13
T O
11
4/13/2009 5/13/2009 6/13/2009 7/13/2009 8/13/2009 9/13/2009 10/13/2009
I N T R O D U C TI O N
Source: JP Morgan
66
INTRODUCTION TO FX OPTIONS
GAMMA-THETA TRADEOFF
x x2
SN' (d1 ) 1 -
Theta, =
2 T
rKe -rT N(d 2 ), where N(x) =
-
2
e 2
1
N S
2
, the first term inside the summation, is called
Assuming constant volatility, P/L in one time step t is given by i
Si
realized variance.
2 i = 1
1 2 +
( S) ( t)
2 2, the second term inside the summation, is called implied
If interest rate r is assumed to be zero, then algebraic manipulation variance. Implied variance (or rather its square root) is quoted in
of the expressions for gamma and theta shown alongside yields the the option market, and is the that is plugged into the BS equation
F O R E I G N
1 2 S
2
2 The square root of variance is called volatility. It is a convention
S (t)
T O
1
N S
2
2 iSi2 i
Si
2 (t)
Finally, do NOT forget the gamma term in the expression. Gamma is
not a constant quantity, and does influence P/L (more on this later)
i =1
67
INTRODUCTION TO FX OPTIONS
Option value po
1 Payout at expiry
Delta-equivalent amount of spot
0
-1
o
96 98 100 102 104 106 108 So S0 + dS
E XC H AN G E
USD/JPY spot
2. Spot inc reases from S o to S o + dS A standard Taylor rule decomposition of changes in option price as a result of
3. Delta inc reases from 0 to 0 +0*dS moves in these variables can be written as follows:
2
7. P/L of long option position = 0*dS +0*dS /2 DELTA VEGA THETA RHO GAMMA
I N T R O D U C TI O N
8. P/L of short spot position = - 0*dS The antithesis of gamma is THETA, often referred to as gamma rent. Theta is
9. Net P/L of long delta-hedged option = 0*dS /2
2 the rate at which an option decays i.e. the P/L bleed of a long option position
simply because of the passage of time.
Note that P/L of the delta-hedged option depends
Note that the gamma trading construct shown earlier assumes instantaneous
ONLY on the MAGNITUDE of the spot move dS, not
spot moves. In practice, sizeable spot moves occur only over a period of time.
its direction (i.e. the sign). This is what is commonly
Hence the option buyer has to pay away rent everyday in the form of theta in
referred to as volatility trading.
order to be long gamma. If spot moves over the life of the option do not
outweigh its time decay, gamma trading will result in negative P/L.
68
INTRODUCTION TO FX OPTIONS
69
INTRODUCTION TO FX OPTIONS
Implied / realized volatility ratios are a commonly accepted and widely used approach G10 gamma matrix
to tracking richness/cheapness of front-end vols
Plotting implied/realized ratios along with implied vol z-scores on the same chart
provides a better perspective on the trade-off between the richness / cheapness of
3M delta-hedged straddles in USD-majors has been a winning trade over the past
month.
EUR-crosses on the other hand appear good sells, largely because moves in the
turn in the rate cycle and in Australia along with, long AUD vol seems to be a
compelling story.
G10 currency pairs ranked in order of 1M Normalized VRP* Gamma performance in the USD-majors over the past month
Monthly P/L (10/15/08-11/14/08) and 6-month statistics for rolling monthly P/Ls
from short 1M straddles* in various USD-pairs, bp of USD notional
F O R E I G N
inf.
Ratio 5th 95th
return avg stdev (ann.) m in %ile m edian %ile m ax
AUD/USD -253 -230 359 -2.2 -904 -758 -128 56 62
EUR/USD -69 -37 68 -1.9 -129 -119 -30 37 46
T O
70
INTRODUCTION TO FX OPTIONS
VOLATILITY SWAPS
As mentioned earlier in the presentation, delta- In a trendless market (left-had chart below), we can
hedged straddles allow one to approximately monetize monetize realized volatility via a delta-hedged straddle,
the difference between implied and realized volatility but in a trending environment, we lose our gamma along
in a non-trending environment. However, in a trending the way.
environment, we lose gamma and can no longer
103 120
effectively monetize the difference between implied
and realized volatility. 102
115
101
One solution to the problem is to own a series of 110
OP TI O N S
100
strikes, thus providing a roughly constant gamma
105 RMS vol = 22.8%
profile. A more efficient solution is to own (or sell) a 99 RMS vol = 16.5%
Mean-adj. vol = 16.9%
volatility swap. 98
Mean-adj. vol = 16.9%
100
hedged option:
I N T R O D U C TI O N
71
INTRODUCTION TO FX OPTIONS
Volatility (% )
11.5
1m, 2m forward
11.0
Forward Vols are often considered to be a systematic
10.5
buy when Spot Vol Curves are inverted, or downward
OP TI O N S
sloping and systematic sells when Spot Vol Curves are 10.0
15
performing. When one or more of the pairs is reacting more
idiosyncratically, outside of the behavior of the rest of the 10
73
I N T R O D U C TI O N T O F O R E I G N E XC H AN G E OP TI O N S
74
INTRODUCTION TO FX OPTIONS
Global FX Strategy
November 5, 2010
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Global FX Strategy
November 5, 2010
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