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Foreign Exchange Operations: Master Trading Agreements, Settlement, and Collateral by David F. DeRosa

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CHAPTER 2

Options on Foreign Exchange

Vanilla and Exotic Currency Options

This chapter provides a general introduction to options on foreign exchange. Options are far more complex than spot or forward transactions. Familiarity with currency options and exotic currency options, especially with their valuation and risk characteristics, is a prerequisite for understanding foreign exchange operations.

Options on foreign exchange (or simply currency options) are widely traded in the interbank market, as can be seen in the BIS survey presented in the previous chapter. Although trading in currency options is a far smaller portion of the overall foreign exchange market than are spot, forward, or forward swaps, currency options by themselves still constitute a large market.

Most of this chapter concerns vanilla or standard puts and calls on foreign exchange. It reviews the basic features of these options and then begins a discussion of the very useful put–call parity relationship. The main event in this chapter is an exposition of the Black-Scholes-Merton model for pricing currency options and understanding their risks. Following on are discussions of volatility, trading basic strategies, and option market making. The chapter then advances to exotic currency options, mostly focusing on barrier and binary options.

OPTION BASICS

In generic option terminology, a call option is the right, but not the obligation, to buy an asset at a set exercise or strike price on or before the option's expiration ...

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