EXCHANGE TRADED CURRENCY OPTIONS

EXCHANGE TRADED CURRENCY OPTIONS (Part 1)

Key Concept 1: Basics of Options

Definition: An option is a contract that gives the option buyer the right, but not the obligation, to buy or sell the underlying asset on or before a specified date/day, at a pre-determined price.
Details: The option buyer pays a premium to the option seller to acquire this right. The option contract specifies the strike price, expiration date, and underlying asset.
Key Terms:
- Call Option: The right to buy the underlying asset.
- Put Option: The right to sell the underlying asset.
- Strike Price: The pre-specified price at which the underlying asset may be purchased or sold.
- Expiration Date: The date at which the option contract will expire or cease to exist.
- Time to Maturity: The difference between the date of entering into the contract and the expiration date.
- Option Buyer: The party that buys the rights but not the obligation and pays a premium.
- Option Seller/Writer: The party that sells the right and receives a premium for assuming the obligation.
- Option Premium: The price that the option buyer pays to the option seller to acquire the right.

Key Concept 2: Difference between Futures and Options

Similarities: Both futures and options have a buyer and a seller, a set price for the underlying asset, and a set settlement date.
Differences: In futures, both parties have the right and obligation to buy or sell, whereas in options, the option buyer has only the right and no obligation.
Risk: The option buyer faces only the risk of premium paid, while the option seller faces unlimited risk.

Key Concept 3: Style of Options

European Options: Can be exercised only on the expiration date.
American Options: Can be exercised on or before the expiration date.
Flexibility: American options offer more flexibility to the option buyer.

Key Concept 4: Moneyness of an Option

In-the-Money (ITM): The option would result in a positive cash flow if exercised.
Out-of-the-Money (OTM): The option would result in a negative cash flow if exercised.
At-the-Money (ATM): The option would result in zero cash flow if exercised.

Key Concept 5: Basics of Option Pricing and Options Greeks

Option Value: Consists of intrinsic value and time value.
Intrinsic Value: The amount by which the option is in the money.
Time Value: The difference between the option premium and the intrinsic value.

EXCHANGE TRADED CURRENCY OPTIONS (Part 2)

Option Pricing Fundamentals

Definition: Option pricing is determined by various factors, including the spot price of the underlying asset, strike price, volatility, time to expiration, and interest rates.
Details: These factors affect the premium or price of options, and their impact can be different for call and put options.

Factors Affecting Option Pricing

Spot Price: An increase in the spot price of the underlying asset increases the value of a call option and decreases the value of a put option.
Strike Price: An increase in the strike price of a call option decreases its intrinsic value and price, while an increase in the strike price of a put option increases its intrinsic value and price.
Volatility: Higher volatility increases the possibility that an option will become profitable, resulting in higher premiums for both call and put options.
Time to Expiration: Longer maturity options have higher premiums due to greater uncertainty, and the time value portion of an option's premium decreases with the passage of time.
Interest Rates: High interest rates increase the value of a call option and decrease the value of a put option.

Option Greeks

Delta (Δ): Measures the sensitivity of an option's value to changes in the underlying asset's price.
Gamma (γ): Measures the change in an option's delta with respect to a small change in the underlying asset's price.
Theta (θ): Measures an option's sensitivity to time decay, representing the change in option price given a one-day decrease in time to expiration.
Vega (ν): Measures the sensitivity of an option price to changes in market volatility.
Rho: Measures the sensitivity of an option price to changes in interest rates.

Relationship Between Factors and Option Value

The following table summarizes the relationship between the factors and the value of call and put options: | Factor | Change in Factor | Call Premium | Put Premium | | --- | --- | --- | --- | | Spot Price | Increase | ↑ | ↓ | | Spot Price | Decrease | ↓ | ↑ | | Strike Price | Increase | ↓ | ↑ | | Strike Price | Decrease | ↑ | ↓ | | Volatility | Increase | ↑ | ↑ | | Volatility | Decrease | ↓ | ↓ | | Time to Expiry | Longer | ↑ | ↑ | | Time to Expiry | Shorter | ↓ | ↓ | | Interest Rates | Increase | ↑ | ↓ | | Interest Rates | Decrease | ↓ | ↑ |

EXCHANGE TRADED CURRENCY OPTIONS

Key Concepts

Vega: Measures the change in an option's price given a 1% change in volatility. For example, if the vega of an option is 0.15, a 1% change in volatility will result in a 0.15 change in the option's price.
Rho (ρ): Measures the change in an option's price given a 1 percentage point change in the risk-free interest rate. Rho is calculated as the change in an option premium divided by the change in the cost of funding the underlying.
Put-Call Parity: Shows the relationship between European put and call options with the same underlying asset, expiration, and strike prices. The equation for put-call parity is C + PV(x) = P + S, where C is the price of the call option, PV(x) is the present value of the strike price, P is the price of the put option, and S is the spot price of the underlying asset.

Option Pricing Methodology

The Binomial Pricing Model: A flexible and intuitive approach to option pricing that can be used for European and American options. The model represents the price evolution of the option's underlying asset as a binomial tree of all possible prices at equally spaced time steps.
The Black-Scholes Model: A popular and relatively simple model for calculating option prices. The model uses the following equation to calculate call and put option prices:
- C = SN(d1) – Xe-rtN(d2)
- P = Xe-rtN(-d2) - SN(-d1) Where:
- S = stock price
- X = strike price
- t = time remaining until expiration, expressed in years
- r = current continuously compounded risk-free interest rate
- v = annual volatility of stock price
- N(x) = standard normal cumulative distribution function
- e = the exponential function
Black (1976) Model: A model for valuing options on futures contracts, bond options, interest rate caps and floors, and swaptions. The model uses forward prices instead of spot prices and is used by Indian exchanges for computing the theoretical price of exchange-traded interest rate options.

Implied Volatility (IV)

Definition: Implied volatility represents the market participant's expectation of volatility over the life of an option. It is a metric used by investors to estimate future fluctuations in a security's price.
Calculation: Implied volatility can be derived from the price of an option by plugging in the other four factors that determine the option price (underlying price, strike price, time to maturity, and rate of interest) into the Black-Scholes model and running it in reverse.
Characteristics: Implied volatility is a dynamic figure that changes based on activity in the options market. It is commonly expressed as a percentage and standard deviation over a specified time horizon. Implied volatility does not predict the direction of price changes, but rather the magnitude of potential fluctuations.

Exchange Traded Currency Options

Introduction to Options

Implied Volatility: When implied volatility increases, the price of options will increase as well, assuming all other things remain constant.
Option Owner: Benefits from increased implied volatility, while the option seller is negatively affected.
Option Seller: Benefits from decreased implied volatility, while the option owner is negatively affected.

Payoff Diagrams for Options

Long Option Position: The buyer of an option has a right but no obligation to buy/sell the underlying asset.
Short Option Position: The seller of an option has an obligation but no right to buy/sell the underlying asset.

Long Call

Definition: A call option gives the buyer the right, but not the obligation, to buy the underlying at the strike price.
Key Characteristics:
- Maximum loss is limited to the premium paid.
- Maximum profit is unlimited.
- Break-Even Point (BEP): Strike price plus premium (X + c).

Short Call

Definition: A call option gives the seller an obligation, but not the right, to sell the underlying at the strike price.
Key Characteristics:
- Maximum gain is equal to the premium received.
- Maximum loss is unlimited.
- BEP is equal to X + P.

Long Put

Definition: A put option gives the buyer the right, but not the obligation, to sell the underlying at the strike price.
Key Characteristics:
- Maximum loss is limited to the premium paid.
- Maximum profit is when the price of the underlying falls to zero at expiry.
- Break-Even Point (BEP): Strike price minus premium (X - P).

Short Put

Definition: A put option gives the seller an obligation, but not the right, to buy the underlying at the strike price.
Key Characteristics:
- Maximum profit is equal to the premium received.
- Maximum loss is when the price of the underlying falls to zero at expiry.
- BEP is equal to X - P.

Key Concepts

Premium: The price paid for an option contract.
Strike Price: The price at which the underlying asset can be bought or sold.
Break-Even Point (BEP): The price level at which the option buyer makes neither a profit nor a loss.
Implied Volatility: A measure of the market's expected volatility of the underlying asset.

EXCHANGE TRADED CURRENCY OPTIONS (Part 5)

Key Concept 1: Payoff Diagram for Short Put Position

Definition: The payoff diagram for a short put position shows the potential gains and losses for the seller of the put option.
Details: The maximum gain for the seller is the premium received, while the maximum loss is unlimited if the underlying price becomes zero.

Key Concept 2: Asymmetric Risk Exposure

Definition: Options have asymmetric risk exposure, meaning the potential gains and losses are not equal.
Details: For example, a call option buyer's loss is limited to the premium paid, while the potential gain is unlimited if the stock price rises.

Key Concept 3: Squaring Off Option Positions

Definition: Squaring off an option position means closing the position before expiry.
Details: This can be done to realize gains or limit losses, and the net payoff is the difference between the premium received and the premium paid.

Key Concept 4: Contract Specification of Exchange-Traded Currency Options

Definition: Exchange-traded currency options have specific contract specifications, including underlying currency, unit of trading, and price quotation.
Details: The contract specifications for exchange-traded currency options are as follows:
- Underlying: USDINR, EURINR, GBPINR, JPYINR
- Unit of Trading: 1000 units of the underlying currency
- Price Quotation: Premium quoted in Indian Rupees
- Contract Value: Trade price * 1000
- Tick Size: Rs. 0.0025 (0.25 paise)
- Price Band: Based on delta and volatility, with a minimum operating range
- Trading Hours: Monday to Friday, 9:00 a.m. to 5:00 p.m.
- Contract Trading Cycle: 3 serial monthly contracts, followed by 3 quarterly contracts
- Option Type: Premium style European Call & Put Options
- Strike Price Interval: Rs. 0.25
- Number of Strikes: Minimum 12 in-the-money, minimum 12 out-of-the-money, and 1 near-the-money strike
- Expiry Day: Two working days prior to the last business day of the expiry month at 12:30 PM
- Mode of Settlement: Cash settled in Indian Rupees
- Final Settlement Price: FBIL reference rate on the last trading day
- Final Settlement: T+2 basis, where T denotes the expiry date

Key Concept 5: Cross Currency Option Contracts

Definition: Cross currency option contracts involve currencies other than the Indian Rupee.
Details: The contract specifications for cross currency option contracts are as follows:
- Underlying: EURUSD, GBPUSD, USDJPY
- Unit of Trading: 1000 units of the underlying currency
- Price Quotation: Premium quoted in USD or JPY
- Contract Value: Trade price * 1000
- Tick Size: USD 0.0001 or JPY 0.01
- Price Band: Based on delta and volatility, with a minimum operating range
- Trading Hours: Monday to Friday, 9:00 a.m. to 7:30 p.m.
- Contract Trading Cycle: 3 serial monthly contracts, followed by 3 quarterly contracts
- Option Type: Premium style European Call & Put Options
- Strike Price Interval: USD 0.005 or JPY 0.5
- Number of Strikes: Minimum 12 in-the-money, minimum 12 out-of-the-money, and 1 near-the-money strike
- Expiry Day: Two working days prior to the last business day of the expiry month at 12:30 PM
- Mode of Settlement: Cash settled in Indian Rupees
- Final Settlement Price: FBIL reference rate on the last trading day
- Final Settlement: T+2 basis, where T denotes the expiry date

Key Concept 6: Comparison of Exchange-Traded Currency Options and OTC Currency Options

Definition: Exchange-traded currency options and OTC currency options have different characteristics.
Details: The main differences between exchange-traded currency options and OTC currency options are:
- Operational Mechanism: Exchange-traded options are traded on a centralized platform, while OTC options are bilateral transactions.
- Terms of Contracts: Exchange-traded options have standardized contracts, while OTC options have customized contracts.
- Price Discovery: Exchange-traded options have price discovery through free interaction of buyers and sellers, while OTC options have price discovery through negotiation.
- Liquidity: Exchange-traded options have high liquidity, while OTC options have low liquidity.
- Settlement: Exchange-traded options have clearing and settlement through a clearing corporation, while OTC options have bilateral settlement.
- Quality of Information: Exchange-traded options have high transparency, while OTC options have low transparency.
- Advantages: Exchange-traded options have price transparency, elimination of counterparty credit risk, and guaranteed settlement, while OTC options have customized products.

EXCHANGE TRADED CURRENCY OPTIONS (Part 6)

Benefits of Exchange Traded Currency Options

Delivery-based settlement: More helpful to importers and exporters.
Access to all types of market participants: Allows for a diverse range of market players.
Clearing corporation guarantee: Reduces credit risk.
Lower liquidity risk: Compared to Over-The-Counter (OTC) options.
Lower impact cost: Reduces the cost of executing a trade.
Easy entry and exit: Facilitates simple participation in the market.
Flexibility in using various option strategies: Allows for diverse trading approaches.

Limitations of Exchange Traded Currency Options

Liquidity risk: May affect the ability to buy or sell.
Counterparty risk: Although reduced by the clearing corporation, still present.
Limited market participants: May restrict the depth of the market.
Restrictions on option strategies: Standardized contracts may limit flexibility.
Imperfect hedge: Due to standardized contract sizes and settlement dates.
Operational issues related to margin: Requires careful management.

Sample Questions and Answers

The price which option buyer pays to option seller to acquire the right is called as d. Premium.
Option buyer faces a. Limited risk and option seller faces Unlimited risk.
An option is a. In the money, if on exercising it, the option buyer gets positive cash flow.
The difference between option premium and intrinsic value is b. Time Value.
The breakeven point for the transaction can be calculated by adding the premium to the strike price, so the breakeven point would be 75.8 (75.5 + 0.3).