Structure of the Market - Forex Management

Options are purchased and traded either on an organized exchange (such as the Philadelphia Stock Exchange on in the over-the counter (OTC) market. Exchange traded options or listed options are standardized contracts with predetermined exercise prices, standard maturities (one, three, six, nine, and twelve months), and fixed maturities (March, June, September and December). Options are traded in standard contracts half the size of the IMM futures contracts, Cross-rate options are also available for the DM/Y,
£/DM, and £/Y. By taking the U.S. dollar out of the equation, cross-rate option allow one to hedge directly the currency risk that arises when dealing with non dollar currencies. The PHLX trades both American style and European style currency options. It also trades month end options which ensures the availability of a short-term currency options at all times and long term options which extend the available expiration months on PHLX dollar based and cross rate contracts providing for 18, 24, 30 and 36 months European style options. On a later date the PHLX introduced a new option contract – called Virtual Currency Option, which is settled in us dollars rather than in the underlying currency.
Other organized options exchanges are located in Amesterdam (European Options Exchange), Chicago (Chicago Mercantile Exchange) and Montreal (Montreal Stock Exchange) OTC options are contracts whose specifications are generally negotiated as to the amount, exercise price and rights, underlying instrument, and expiration. OTC currency options are traded by commercial and investment banks in virtually all finance centers. OTC activities is concentrated in London and New York and it centers on the major currencies, most often involving U.S. dollars against pounds sterling, Deutsche marks, Swiss francs, Japanese yen, and Canadian dollars Branches of foreign banks in the major financial centers are generally willing at write options against the currency of their home country.

The structure of the OTC options market consists of two sectors-

Retail Market:
This market is composed of nonblank customers who purchase from banks what amounts to customized insurance against adverse exchange rate movements and,

Whole Sale Market
A whole sale market is composed of commercial banks, and specialized trading firms. This is mainly involve in inter bank OTC trading, trading on the organized exchanges.
Most retain customers for OTC options are either corporations active in international trade of financial institutions with multicurrency asset portfolios.
These customers could purchase foreign exchange puts of calls on organized exchanges, but they generally turn to the banks for options in order to find precisely the terms that match their needs. Contracts are generally tailored with regard to amount, strike price, expiration date and currency.

Currency call Options:
After understanding the structure of the currency option market- both the retail and the whole sale markets, it would be useful to understand the currency call options. In the following paragraphs we would be involved in understanding the currency options available to a buyer.
A currency call option is a contract that gives the buyer the right to buy a foreign currency at a specified price during the prescribed period. Firms buy call options because they anticipate that the spot rate of the underlying currency will appreciate. Currency option trading can take place for hedging or speculation.

Hedging in the call Option Market:
Multinational companies with open positions in foreign currencies can utilize currency call options. For example, suppose that an American firm orders industrial equipment form a German company, and its payment is to be made in German marks upon delivery. A German mark call option call option lacks in the rate at which the U.S company can purchase marks for dollars. Such an exchange between the two currencies at the specified strike price can take place before the settlement date. Thus the call option specifies the maximum price which the U.S. company must pay to obtain marks. If the spot rate falls below the strike price by the delivery date, the importer can buy marks at the prevailing spot rate to pay for its imports and can simply let its call option expires.

Speculating in the call Option Market:
Firms and individuals may speculate with currency call options based on their expectations of exchange-rate fluctuations for a particular currency. The purpose of speculation in the call option market is to make a profit from exchange rate movements by deliberately taking an uncovered position. If a speculator expects that the future spot rate of a currency will increase, he makes the following transactions:

The speculator will:

  1. Buy call options of the currency
  2. Wait for a few months until the spot rate of the currency appreciates high enough
  3. Exercise his option by buying the currency at the strike price, and
  4. Sell the currency at the prevailing spot rate.

In order to understand it better let us have an example:
Assume that the call premium per English pound on March 1 is 1.10cents, the expiration date is July, and the strike price is $1.60. Ms. Stuti anticipates that the sot rate of the pound will increase to $ 1.70 by June 1. If Ms. Stuti’s expectation proves correct, what would be her dollar profit from speculating one pound call option in the call option market?

Ms. Stuti could make a profit of $2,781.25 by doing the following trading activities:
1. Buy call options on March 1 -$0.0110 per pound
2. Exercise the option on June 1 -$1.6000 per pound
3. Sell the pound on June 1 +$1.7000 per pound
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4. Net profit as of June 1 +$0.0890 per pound
5. Net profit per contract £31,250x$0.0890=$2,781.25

Stuti does not need to exercise her call options in order to make a profit. Currency call option premiums raise and fall as exchange rates of their underlying currency rise and fall. If call options become profitable, their premiums will rise. They can be sold on an exchange just like any foreign currency itself. Therefore, a call option holder such as Stuti can save the expense and bother of taking possession of the currency and selling it.

Currency Put Options:
A currency put option is simply a contract that gives the holder the right to sell a foreign currency at a specified price during a prescribed period. People buy currency put options because they anticipate that the spot rate of the underlying currency will depreciate. Multinational companies who have open positions in foreign currencies can employ currency put options to cover such positions. For example, assume that an Indian company which has sold an airplane to a Japanese firm and has agreed to receive its payment in Japanese yen. The exporter may be concerned about the possibility that the yen will depreciate when it is scheduled to receive its payment from the importer. To protect itself against such a yen depreciation, the exporter could buy yen put options, which would enable it to sell yen at the specified strike price. In fact, the exporter would lock in the minimum exchange rate at which it could sell Japanese yen in exchange for U.S. dollars over a specified period of time. On the other hand, if the yen appreciates over this time period, the exporter could let the put options expire and sell the yen at the prevailing spot rate.
Individuals may speculate with currency put options based on their expectations of exchange rate fluctuations for a particular currency. For example, if speculators believe that the German mark will depreciate in the future, they can buy mark put options, which will entitle them to sell marks at the specified strike price. If the mark’s spot rate depreciates as expected, they can buy marks at the spot rate and exercise their put options by selling these marks at the strike price. Speculators do not need to exercise their put options in order to make a profit. They could make a profit from selling put options because put option premiums fall and rise as exchange rates of the underlying currency rise and fall. The seller of put options has the obligation to purchase the specified currency at the strike price from the owner who exercises the put option. If speculators anticipate that the currency will appreciate, they might sell their put options. But if the currency indeed appreciates over the entire period, the put option will mot e exercised. On the other hand, if they expect that the currency will depreciate, they will keep their put options. Then they will sell their put options when the put option premiums go up.

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