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Financial DerivativesFinancial Derivatives

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4. Currency Option

i. Definition : Currency option is a financial contract (as product or instrument) under which the buyer of option gets right to buy or sell the underlying currency.

For this the Buyer pays the premium to the seller of option.

There are two types of currency option :

Currency Call Option Currency Put Option

Gives the right to the buyer Gives the right to the buyer

of option to buy of option to Sell Underlying Currency Underlying Currency

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ii. USD INR Currency Option Future

• Underlying Currency USD

• Trading or Price Currency INR

• Contract Size 1000$

• Contract Cycle 3 Consecutive Month + 1

• Option Type European

• Premium In Rupees

• Tick Size .25 paisa (.0025 Rs)

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iii. Operational Issue :

a) In India USD INR option is available as Exchange Traded Product as well as OTC Product. Other Foreign currency Vs INR product are available as OTC product.

b) How to Identify Underlying Currency and Trading/Price Currency ?

Underlying Currency Trading or Price Currency

The currency in which Contract Size is given.

The currency in which Strike Price and Premium are expressed.

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iv. Hedge Strategy

Exporter Importer

Concern

Hedge

Instrument

Falling Price of Foreign Currency

Rising Price of Foreign Currency

Currency Put Option

Gives right to Sell Underlying Currency

Currency Call Option

Gives right to Buy Underlying Currency

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v. Hedge Efficiency

We know that hedging is done by creating Offsetting (opposite) Position in derivative market.

The Overall idea is to recover the loss incurred on spot position in the derivative position.

The Hedge Efficiency is measurement of performance of the Hedge process. For this we compare Loss/Gain on spot position with Gain/Loss on derivative position.

A `Perfect Hedge` or 100%. Hedge Efficiency means entire loss is recorded.

If question requires to calculate `Hedge Efficiency` than we should assume CASH settlement in derivative market.

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vi. While comparing number of hedge strategies we should assume Physical Settlement for Option contract.

vi. Open Transaction Close Transaction

When you start with buy or sell position ( entering into option contract)

A transaction which closes the previous transaction. (by cancelling out)

This is possible before the expiry date.

If a person enters into an option contract, he can cancel out (close out) the previous position ( long or short) any time before expiry date by creating offsetting position

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viii. Philadelphia Stock Exchange (PSE) is the largest Exchange for currency option in the world.

Strike Price and premium are expressed in cents except for JPY in which strike price and premium are expressed in hundredths of cents.

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