FX Options Fundamentals

FX Options
Fundamentals
January 2006
Jean-Marc Servat
Director - FX Structuring - London

Options Fundamentals: Agenda
 Why Use Options?
 Definition and Payout Profiles
 Modelling Assets, Trees, Volatility
 Value of Options: Time Value and Intrinsic Value, Drivers of Option Prices
 Risk Management: Delta Hedging in Practice, Sensitivities, Greeks
 Theory behind Delta Hedging
 Call-Put parity
 Fat tails, Smile and Volatility Surface
 Classic Combinations of Vanilla Options
CitiFX Structuring 2
Why Use Options?
 Hedge a Specific Exposure: non constant, exposed over a range, currency
clauses
 Express a Precise Market View
 Protect Uncertain Exposures from FX fluctuations
• Volatile Forecasted Exposures: Business uncertainty
• Contingent exposures: bid to award
 Hedge Short Option Exposures: global product arbitrage
 Minimize VaR
 Trade Volatility as an uncorrelated asset class
What instruments are you using? Why?
Definitions
and
Payout Profiles
Definition
 An option is a financial contract giving the buyer of the derivative, the right, but
not the obligation to buy (for Call / Sell for a Put) a specified notional of
currency against another one at a specific rate, on a specific date.
 The seller of the option has the obligation to transact on the pre-agreed
terms, if the owner exercise the option.
 A rational buyer will only exercise the option if the action is beneficial
 … compare with a Forward: both parties have the obligation to transact
VOCABULARY: Call, Put, Vanilla, Premium, Notional, Nominal,

Strike,Underlying, Spot, Expiry, Tenor, Exercise,Deliver, Write
Analogy: a Call Option on Equities
The right to BUY: In a pre-agreed

Call (vs: SELL = Put) amount: the notional
An Asset: the
Underlying
1-year 50.25 Call on 1000 Shares of XYZ Inc.
At a specific price: the strike

(here is USD)
On (*) a pre-defined date: the expiry
It is the right to exchange 2 Assets at a pre-defined rate, on a given date
(*) for European Options

A Call on a Share is a Put on USD… On or Before = American options
FX Call Option
The right to BUY: In a pre-agreed

Call (vs: SELL = Put) amount: the notional
An Asset: the
Underlying
1-year 1.2000 EUR Call (USD Put) on 10 000 000 EUR
At a specific price: the strike in

USD per EUR
On (*) a pre-defined date: the expiry
It is the right to exchange 2 Assets at a pre-defined rate, on a given date
(*) for European Options

A Call on a EUR is a Put on USD… On or Before = American options
Understanding the Definition
“The right, but not the obligation to buy, at a specific strike, on a specific date”
Option holder will exercise at expiry if it is optimal.
P&L
At expiry
In term
ccy
Long Option Spot

0
= the right Premium
(paid)
to transact
Strike
OUT OF AT IN
the the the
Money Money Money
An Option is a “non linear instrument”
The Value (P&L) of a forward is a linear function of Spot
The Value of the option is a curve.
Value
Now
What brings the Value UP

when spot is below strike?
•the right to walk out of the 0

forward (definition) Spot
Strike
•the long gamma position…
Call Option
Forw ard
Value is expressed in term ccy

Eg: USD in EURUSD
Payout Profiles of Elementary Options (“Vanillas”)
Long Call Long Put
P&L P&L
At expiry At expiry
In term
Long Option ccy
= the right 0 Spot 0 Spot

Premium
to transact (paid)
Strike
Short Call Short Put

P&L P&L
Short Option At expiry
In term
At expiry
= the obligation ccy

Premium
(received)
to transact 0 Spot 0 Spot
upon request
VOCABULARY: At-the-Money (F,S), In-the-Money, Out-of-the-Money

Premium of an Option
Multiply by Spot
EUR USD
Premium in
EUR USD
Nominal in
EUR % EUR (basis points) USD pips per EUR
Divide
by Strike
USD EUR pips per USD % USD (basis points)
Premium in
Example EUR USD
Spot: 1.2024 Nominal in
Strike: 1.2084 ATMF 3M
EUR Nominal 10,000,000 EUR 1.8120% 0.0218
USD Nominal 12,084,000
EUR Premium 181,154
USD Premium 218,906 USD 0.0150 1.803%
Modelling Asset Prices
Trees
Volatility
Random Walk
Ball can go left or right at Geometric Brownian

each point with equal Motion = movement of
probability elementary particles
A particle position is
unknown but
expected…
Forward
Volatility Definition
Volatility =Annualized Standard

Deviation of Log-Returns Low Volatility
EUR CHF
Realized Volatility = measure of

past volatility of spot over a Moderate Volatility
period EUR USD
Implied Volatility = price

quoted by market makers for High Volatility
options. Should be the expected USD ZAR
volatility over the life of the
option
Implied and Historical Volatility
1.40
Spot
Today
FWD
1.35
High Band 90%
Low Band 10%
1.30
1.25
1.20
6m Historical
1.15 Volatility
1.10
6m Implied
Volatility
1.05
1.00
ov-03
ov-05
ov-04
Jun-05
Jun-04
Jul-04
ay-04
Jul-05
ay-05
ug-03
ug-04
Jan-05
ug-05
Jan-04
Jan-06
ep-03
ec-05
ec-03
eb-04
ep-04
ec-04
eb-05
ep-05
eb-06
Oct-03
ar-04
Apr-04
Oct-04
ar-05
Apr-05
Oct-05
Properties of the Normal Distribution
99%
What is the expected +/- 2.6 σ
trading range, given
an implied volatility? 95%
+/- 1.96 σ
68%
Note: 2-tail test vs
VaR 1-tail test +/- 1 σ
Forward
Key concept for Value-At-Risk (VaR)
P&L of a 100
Probabilities
Option Pricing – Binomial Trees
Strike Call
An intuitive view about how 120.00 20.00 1/256
to price options Call Strike 100 117.50
115.00 115.00 15.00 8/256

50% (*)
112.50 112.50
110.00 110.00 110.00 10.00 28/256

107.50 107.50 107.50
105.00 105.00 105.00 105.00 5.00 56/256

102.50 102.50 102.50 102.50
Start 100 100.00 100.00 100.00 100.00 0.00 70/256
97.50 97.50 97.50 97.50
95.00 95.00 95.00 97.50 0.00 56/256
92.50 92.50 92.50
90.00 90.00 90.00 0.00 28/256

50% 87.50 87.50
85.00 85.00 0.00 8/256

After 8 time steps,
82.50
There are 256 possible paths
80.00 0.00 1/256
Value of Options:
Time and Intrinsic Value
Drivers of Options price
Option Value = Intrinsic Value + Time Value
 Intrinsic Value is given by the Forward Rate and the Strike Price:
Calls = Max {0, Forward – Strike}
Put = Max {0, Strike – Forward}
 Intrinsic value is the value of the option if you were to exercise it today at current forward rate
 Option Value = Intrinsic Value + Time Value
Intrinsic Value
Value
Time Value
Spot
Strike
Drivers of FX Option Prices
Strike Spot Volatility
K S Delta σ Vega
Pricing Theoretical
Model Value
Black –Scholes Formula for a Call:

Interest Time to
Rates Expiry
r, q Rho T Theta Call = Se − qT Ν ( d1 ) − Ke − rT Ν ( d 2 )
Tho
S σ2
S = current Spot Rate (1 Foreign = S Domestic) ln  + (r − q + )T
d1 =  
K 2
K = Strike Rate
r = domestic continuously compounded risk free interest rate σ T
q = foreign continuously compounded risk free interest rate
T = time in years till expiry
N() = standard normal cumulative distribution function d 2 = d1 − σ T
σ = implied volatility
Drivers of FX Option Prices
What Driver Call Put
happens to
option price Spot (S)
if drivers
increase in Tenor (T)
value?
Implied Volatility (σ )
IR Foreign (q)
IR Domestic (r)
Black and Strike (K)

Scholes formula
re-arranged with
the Forward
F σ 2T F σ 2T
ln( ) + ln( ) −
Call = e − rT ( FN (d1 ) − KN (d 2 ) ) d1 = K 2 d2 = K 2 = d −σ T
1
σ T σ T
Risk Management
Delta-Hedging in Practice
Sensitivities
Greeks
Definition of Greeks
Option positions give rise to various risks:
 Delta : change in option price for changes in underlying spot
 Gamma: rate of change of delta with spot
 Theta: change in price of an option for a unit change in time (time decay)
 Vega: change in option price given a one percent increase in implied volatility
These are called the Greeks.
Option trading is managing these risks.
Spot Sensitivity: P&L and Delta
3 months to Expiry P&L= Value relative to Spot

2 months to Expiry
1 month to Expiry As time goes by, time value decays
At-Expiry
and curves gets close to “at expiry”
P&L
Spot
Delta
Delta = change of Value relative to Change 3 months to Expiry
2 months to Expiry
in Spot = First derivative 1 month to Expiry
At-Expiry
Spot
Delta is positive between 0% and 100%
(for a Call)
More about Delta
 Delta represents the equivalent underlying position that would give the same
P&L as the derivative for a small move in spot.
 If you hold the derivative and take the opposite delta position, you isolate
yourself from spot risk for short moves
Option Position Breakeven Graph Net Cash Position On Delta Hedge
Long Call Long Sell Outright
Long Put Short Buy Outright
Short Call Short Buy Outright
Short Put Long Sell Outright
Practicing Delta-Hedging
Let’s use Fox Online, mid spot, swaps and vol
• Long a 1 month 50-delta GBP Call (OEC code), take note of premium, check Risk Graph - Plot P&L
• Hedge with Forward transaction (FX code), Check Risk Graph, Plot P&L
• Then move spot up, check the delta, delta hedge (sell GBP) at new forward
• Move spot back to initial level, what is the delta? What is the new value of portfolio?, Why? Delta hedge
again.
• Move spot down, check delta, delta hedge (buy GBP)
• Move spot back to initial level, what is the delta? What is the new value of portfolio?, Why?
Dealing Options and Delta
 2 ways to deal options
• Live price
• Exchanging delta on a Spot reference or Vol Price
 When fixing a Spot Ref, Price will be valid for a small change in spot, if vol does not
change: If spot moves slightly, the slight change of value of the option will be compensated
by the change of value of the spot exchange
 Example: GBPUSD, spot ref 1.7680, Buying 10 Mio GBP a 1.7900 GBP Call 1-month
The delta is 30%, Price is 87 USD pips, Premium = 87 000 USD
When the trade is done, 5 minutes later , spot is at 1.7700
New price of option is USD 93 000
BUT Buyer still pays 87 000 USD AND sells 3 Mio GBP at 1.7680.
Buyer has lost 3 Mio GBP x 20 USD pips = 6 000 USD on the delta hedge
In practice, it is equivalent!
Spot Sensitivity: Delta and Gamma
Delta = change of Value relative to Change

Delta in Spot = First derivative
Delta is between 0% and 100% (for a Call)
3 months to Expiry
2 months to Expiry
1 month to Expiry
At-Expiry
Spot
3 months to Expiry
Gamma = change of Delta relative to 2 months to Expiry
Change in Spot = Second derivative Gamma 1 month to Expiry

At-Expiry
Gamma options = short dated

Gamma is what makes an option a non
linear instrument
Implied Vol is the price of an option = the
price of gamma Spot
Other Risk Parameters: Vega and Theta
Vega = change of Value relative to Change

Vega 3 months to Expiry
2 months to Expiry
in Implied Volatility
1 month to Expiry
At-Expiry Vega is maximal at the money
Vega options = long dated
Spot Spot
Theta = Time decay 3 months to Expiry

2 months to Expiry
Daily change of Value by tomorrow 1 month to Expiry

At-Expiry
Theta is maximum at the money

and for short dated options
Negative Theta (time decay) is the trade off
Theta
of a long gamma position
One pays premium for the right to choose
Greeks of Calls and Put, Long and Short
+ Call + Put - Call - Put
Delta
+ - - +
Gamma
+ + - -
Vega
+ + - -
Theta
- - + +
What is the best way to get long? Buying a Call or Selling a Put?
Compare Gamma and Vega..
Compare Gamma and Theta…
The Theory
Behind Delta-Hedging
Theory - Discounting with the Appropriate Rate
 Theory : Investors expect higher returns when taking risk, ie expected return is higher when return is volatile
 For a given, uncertain asset, at which rate should we discount cash flows ?
 Example : Risk Free Rate of Return, Rf = 5%
Asset 1 Asset 2
certain CF of 105 in 1 year 50% chance of 210, 50% = 0 in 1 year
Now 1 year T1
P = 50%
210
Now 1 year T1
PV = 100 105 Expected

Value Volatility
PV < 100 Discounting
at R = ? > 5% 105
Discounting
at Rf=5%
P = 50% 0
A rational investor will require more than 5% return if there is volatility ⇒

Asset 2 has a lower Present Value than Asset 1 1.
Theory - Risk Neutral Valuation
Which World ? Investors’ attitude Discount Rate Probabilities
Risk Averse (real Require compensation Ra P1, P2...

world) for Risk
(adjusted by risk True probabilities
premium)
Risk Neutral Indifferent to Risk Rf P´1, P´2…
(Risk free) Risk adjusted
probabilities
 Valuing the option :
 estimating the Ra risk–adjusted rate,
or
 creating a risk free portfolio (option with delta-hedge) and express the value of the option
as the Rf discounted value of the expected value under Risk Neutral probabilities
Theory - Risk Neutral Valuation: Why is Delta
hedging so important?
Now Now + T
S0 u S = price of underlying at time 0
o
f = price of derivative at time 0

fu S u = price of underlying at expiry after an up move
o
S0 (u>1)
S d = price of underlying at expiry after a down move
f
o
(d<1)
f = price of derivative at expiry after an up move
S0 d u
f = price of derivative at expiry after a down move

d
fd r = risk free rate of return
Let’s create a portfolio made of the derivative and an amount of underlying, so that the portfolio future value has no
uncertainty
fu − f d
S 0 d∆ − f d = S 0u∆ − f u ⇒ ∆=
S 0u − S 0 d
This portfolio has the same value in the
2 states of the world : It is risk neutral This is the amount of underlying needed
to neutralize the derivative
S 0 ∆ − f = ( S 0u∆ − f u )e − rT ⇒ f = S 0 ∆ − ( S 0u∆ − f u )e − rT
Because there is no uncertainty, We deduct the current price of the derivative
we can discount at the risk free rate of return
− rT e rT − d
We can simplify to f =e [ pf u + (1 − p ) f d ] where p=
CitiFX Structuring 34 u−d
Theory - Risk Neutral Valuation
− rT
f = e [ pfu + (1 − p) f d ] e rT − d
where p=
u− d
 f is the expected value under a probability p of the future pay-offs of the option, discounted at the risk free rate of return
 p and (1-p) are called the risk neutral probabilities
 p does not depend of the real world probabilities of a move up or down
 Counter-intuitive!
 Because these probabilities are already in the spot price!
The expected value of the underlying is pS0u + (1 − p) S0 d

when we replace p by its value and simplify, we get E ( ST ) = S0e rT
Analytical formulas (B&S)

Provides the base of valuation methods
Trees / Lattices / Finite Difference
Put-Call Parity
Put-Call Parity
 With same strike: Call - Put = Forward
P&L
At expiry
In term
ccy Forward
Long Call Example:
Long 1-Month EUR Call 1.20

0
on 10 Mio
=
Long 10 Mio EUR at 1-Month
Forward rate 1.20
Short Put
+
Long 1-Month EUR Put on
10 Mio EUR
Put-Call Parity in Practice
 Spot is 1.2120. A 1-month EUR Call 1.2325 is a 30 delta. What is the delta
of a 1.2325 Put?
 The Call trades at 9.3% vol. What is the volatility price of the Put, same
strike?
 Spot is 1.2120. 1-month Forward is 1.2145. The 1.2325 is worth 63 USD

pips. What is the value of the 1.2325 Put?
 What are the Time and Intrinsic Value of these Calls and Puts?
Smile,Strangle,Risk Reversal
and Volatility Curve
Black & Scholes Model Imperfections
The Black & Scholes Pricing Model assumes

 Constant Volatility in time
 That Currency returns are normally distributed
However,
 Volatility is not constant
 Empirically, currency returns exhibit leptokurtosis (peaky distribution with fat
tails)
 Nevertheless the 1973 formula is still used today!
When markets don’t follow a Normal Distribution
 USD JPY October 1998
 Normal distribution says that a once every 20 000 years, there will be a 5
standard deviation move…ie: 7% for a 48 hours trading period.
150
140
11% move in 2 weeks
14% move in 48 hours

130
120
110
100
90
Aug-96
Aug-97
Aug-98
Apr-96
Jun-96
Apr-97
Jun-97
Feb-98
Apr-98
Jun-98
Feb-99
Apr-99
Feb-96
Feb-97
Dec-95
Dec-97
Dec-98
Dec-96
Oct-98
Oct-95
Oct-96
Oct-97
Market Adjusted…
The Option Market has adapted by

 Keeping the same pricing formula for Vanilla Option
 Each strike (delta) is priced with a specific volatility
 Adjusting higher the price of OTM options
 Differentiating the vol price of OTM Puts and Calls
 This is known as “Volatility Smile”
Determinants of the Vol Smile are

 Risk Reversals
 Strangles
Strangles: the Price of Tail Events
Strangles
 They measure the vol price difference between ATM options and OTM
options
 25 and 10 Delta have become the market reference
 Per convention:
Call25Delta + Put 25Delta

Strangle 25Delta = − Vol ATM
2
Call10Delta + Put10Delta
Strangle10Delta = − Vol ATM
2
 This corrects for the “fat tail” issue
Effect of Strangles
Effect of Strangles on Smile
ATM
Volatility Prices
Strangle Prices
Increase
B&S Theo
0% Call 100%
Delta
100% Volatility
Put Delta 0%
Risk Reversals: Skewness
Risk Reversals
 They measure the vol price difference between OTM Calls and Puts
having the same Delta
 25 and 10 Delta have become the market reference
 Per convention:
Risk Reversal25Delta = Call25Delta − Put 25Delta
Risk Reversal10Delta = Call10Delta − Put 10Delta
 This corrects for the fact volatility changes as spot changes
Effect of Risk Reversal
Effect of Risk Reversals on Smile
ATM
Volatility Prices
OTM Calls > OTM Puts >

OTM Puts OTM Calls
B&S Theo
0% Call 100%
Delta
100% Volatility
Put Delta 0%
Interpreting Risk Reversals
 Because Risk Reversals measure the price difference between OTM

Calls and Puts, they are often interpreted as the markets directional
view.
 This is wrong!
 They reflect the expected move in implied vol given a move in spot.
 The higher the RR’s absolute value, the more sensitive the implied vol to
spot movements.
 It has been empirically demonstrated that RR don’t have any directional
predictive value on the underlying.
Pricing OTM Options
 Strangles, Risk Reversals and ATM prices may be used to determine the vol price of individual OTM options:
1
Call xDelta = Vol ATM + Strangle xDelta + Risk ReversalxDelta
2
1
Put xDelta = Vol ATM + Strangle xDelta − Risk ReversalxDelta
2
USD-JPY Volatility Surface
12.00%
11.00%
Example: ATM 10%, 25D RR +0.5%, 25D Strangle +0.25% 10.00%
Call (25 Delta) = 10% + 0.25% + ½*0.5% = 10.5% 9.00%
8.00%
Put (25 Delta) = 10% + 0.25% - ½*0.5% = 10.0%
7.00% 2.00
5
15
25
35
Tenor (yrs)
45
55
65
0.02
75
Delta
85
95
Classic Combination
of
Vanilla Options
Classic Combinations
Collar
Call Spread
Straddle Strangle (Risk Reversal) Long Call lower Strike,
Long Call and Put Long Call and Put Long Call, Short Put Short Call higher strike
same strike different strikes different strikes
Strike
- Bullish
- Non directional - Non directional - Bullish with a target
- Adapted to Stop
- Volatile - Very Volatile - Cheaper than Call
Loss / take Profits
Seagull Butterfly Ratio Call Spread

Short Straddle Long Call Spread Long Straddle Long Call lower Strike,
Short Put Short Strangle Short Call higher strike double notional
- Non directional - Bullish with target - Non Directional - Bullish with a maximum target
- Expects low - Cheaper than Call - Volatile within a - Cheap, can even generate
volatility Spread range premium
Thank you!
CitiFX Structuring
Mark Balascak New York 1-212-723-1113 mark.balascak@citigroup.com

Michele Ghidoni London 44-20-7986-1807 michele.ghidoni@citigroup.com
Alex Godet London 44-20-7986-9381 alexandre.godet@citigroup.com
Stephane Knauf New York 1-212-723-1274 stephane.knauf@citigroup.com
Jean-Marc Servat London 44-20-7986-9379 jeanmarc.servat@citigroup.com
Evon Wong Singapore 65-6328-2859 evon.wong@citigroup.com
Disclaimer
This document does not represent an accounting opinion. The Company should consult with their
auditing firm for further accounting opinion on the proposed transactions.
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FX Options

Director - FX Structuring - London

 Why Use Options?

 Definition and Payout Profiles

 Modelling Assets, Trees, Volatility

 Risk Management: Delta Hedging in Practice, Sensitivities, Greeks

 Theory behind Delta Hedging

 Fat tails, Smile and Volatility Surface

 Classic Combinations of Vanilla Options

What instruments are you using? Why?

 … compare with a Forward: both parties have the obligation to transact

VOCABULARY: Call, Put, Vanilla, Premium, Notional, Nominal,

The right to BUY: In a pre-agreed

1-year 50.25 Call on 1000 Shares of XYZ Inc.

At a specific price: the strike

It is the right to exchange 2 Assets at a pre-defined rate, on a given date

(*) for European Options

The right to BUY: In a pre-agreed

1-year 1.2000 EUR Call (USD Put) on 10 000 000 EUR

At a specific price: the strike in

It is the right to exchange 2 Assets at a pre-defined rate, on a given date

(*) for European Options

Long Option Spot

What brings the Value UP

•the right to walk out of the 0

Value is expressed in term ccy

= the right 0 Spot 0 Spot

Short Call Short Put

= the obligation ccy

VOCABULARY: At-the-Money (F,S), In-the-Money, Out-of-the-Money

EUR % EUR (basis points) USD pips per EUR

USD EUR pips per USD % USD (basis points)

Ball can go left or right at Geometric Brownian

Volatility =Annualized Standard

Realized Volatility = measure of

Implied Volatility = price

An intuitive view about how 120.00 20.00 1/256

to price options Call Strike 100 117.50

115.00 115.00 15.00 8/256

110.00 110.00 110.00 10.00 28/256

105.00 105.00 105.00 105.00 5.00 56/256

Start 100 100.00 100.00 100.00 100.00 0.00 70/256

97.50 97.50 97.50 97.50

95.00 95.00 95.00 97.50 0.00 56/256

92.50 92.50 92.50

90.00 90.00 90.00 0.00 28/256

85.00 85.00 0.00 8/256

 Option Value = Intrinsic Value + Time Value

Strike Spot Volatility

Black –Scholes Formula for a Call:

Black and Strike (K)

Option positions give rise to various risks:

 Delta : change in option price for changes in underlying spot

 Gamma: rate of change of delta with spot

These are called the Greeks.

Option trading is managing these risks.

3 months to Expiry P&L= Value relative to Spot

Option Position Breakeven Graph Net Cash Position On Delta Hedge

Long Call Long Sell Outright

Long Put Short Buy Outright

Short Call Short Buy Outright

Short Put Long Sell Outright

The delta is 30%, Price is 87 USD pips, Premium = 87 000 USD