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Options on Foreign Exchange, Third Edition by David F. Derosa

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CHAPTER 10

Non-Barrier Exotic Currency Options

Non-barrier currency options tend to be used more by hedgers than by currency traders. There is a great variety of non-barrier currency options, but the focus in the chapter will be on the options that are common in the marketplace. Those are average rate currency options, compound currency options, basket options, and quantos options.

AVERAGE RATE CURRENCY OPTIONS

Average rate currency options,1 also called “Asian currency options,” exist in the foreign exchange market but are more prevalent in physical commodities markets.

Average options are useful when a commodity or asset is susceptible to price manipulation. An average option makes it more difficult for either the buyer or writer of the option to be cheated because a series of prices during the averaging period would have to be rigged to materially disadvantage either party.

Average options are also useful in situations where hedgers are primarily concerned with the average price of a commodity or currency of which they must make regular purchases or sales.

Intuitively, one would expect that an average option would have to be less valuable than a vanilla option. This is because the standard deviation of an average of a series of prices that is not perfectly autocorrelated has to be less than the standard deviation of a single price in the series. In other words, the average options should sell for smaller implied volatilities than vanilla options (Kemna and Vorst 1990).

There ...

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