Barrier and Binary Currency Options
Barrier options on foreign exchange are options designed to go out of existence or come into existence when the spot exchange rate trades at or through some predetermined barrier level before option expiration (a barrier event). Similar to barrier options are binary options. Binary options pay a fixed sum only if a barrier level is triggered (Exhibit 8.1).
Presently barrier and binary currency options are traded exclusively in the interbank market. All the major foreign exchange dealing banks offer these options.
For the most part, barrier options are constructed to be susceptible to barrier events at any time in their lives. For this reason they are said to be path-dependent, referring to the fact that the state of their very existence is affected by the spot exchange rate at points in time during their lives before expiration. In contrast, vanilla currency options are not path-dependent because their existence is not affected by intermediate values of the spot exchange rate. As a rule, currency barrier options, unlike barrier options in other markets, do not pay rebates. A rebate is a cash payment made when a barrier event causes an option to be extinguished.1 The models in this chapter assume that barriers are monitored continuously. These models are useful even though ...