Handbook of Exchange Rates

24.1 Introduction

The next few sections provide an overview of foreign exchange (FX) options from the buy-side perspective. The content is split into four main parts: the first two parts are more theoretical and the second two are more practical.

The first part discusses a general “market for options” concept, if an option can be replicated, why the market for options exists and why one may need an option contract. It is followed by a brief outline of the Black–Scholes framework and the main assumptions this framework makes in order to derive the Black–Scholes formula. We demonstrate how these assumptions are quite far from reality and several stylized facts from the FX market show the divergence. As the assumptions are violated, we see how the FX market has adapted to incorporate “reality” into option prices. We discuss further the parallel between an option contract and portfolio insurance strategies, and we see that the cost of an option can be presented as the expected cost of a portfolio insurance strategy.

In the second part, we identify FX options-market participants and we present how they interact with each other. We build a naive volatility trading strategy using options, selling expensive volatility. We also consider a Black Swan strategy, where we buy cheap options to create a protection against potential losses in the rest of a hypothetical portfolio. We try to answer the question whether the FX volatility is an asset class by looking at the value added of the strategies ...