Garman-Kohlhagen (GK) is the standard model used to calculate the price of an FX option, however there are a wide range of techniques in use for calculating the options risk exposure, or greeks. Although the price produced by every model will agree, the risk numbers calculated by different models can vary significantly depending on the assumptions used for the properties of the spot price movements, volatility surface and interest rate curves.
After GK, the most common models in use are SABR and local volatility, although when agreeing risk numbers with a counterparty (e.g. for exchanging delta, or calculating the strike on a 25 delta option) the Garman-Kohlhagen numbers are always used.
Tuesday, March 17, 2009
Hedging with FX options
Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.
Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.
If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.
Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which will:
. protect the GBP value that the firm will receive in 90 day's time (presuming the
cash is received)
. cost at most the option premium (unlike a forward, which can have unlimited
losses)
. yield a profit if the expected cash is not received but FX rates move in its favor
Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.
If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.
Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which will:
. protect the GBP value that the firm will receive in 90 day's time (presuming the
cash is received)
. cost at most the option premium (unlike a forward, which can have unlimited
losses)
. yield a profit if the expected cash is not received but FX rates move in its favor
Foreign Exchange Option
In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158,300 billion in 2005
The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158,300 billion in 2005
Currency Swap
A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in another currency. Currency swaps are motivated by comparative advantage.
Structure
Currency swaps can be negotiated for a variety of maturities of up to 30 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract.
Unlike interest rate swaps, currency swaps involve the exchange of the principal amount. Interest payments are not netted (as they are in interest rate swaps) because they are denominated in different currencies. Further, many currency swaps are traded on organized exchanges - lowering counter-party risk, as evidenced by the bid-ask spread on most listings. See also John Hull.
Structure
Currency swaps can be negotiated for a variety of maturities of up to 30 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract.
Unlike interest rate swaps, currency swaps involve the exchange of the principal amount. Interest payments are not netted (as they are in interest rate swaps) because they are denominated in different currencies. Further, many currency swaps are traded on organized exchanges - lowering counter-party risk, as evidenced by the bid-ask spread on most listings. See also John Hull.
Forex Swap-Pricing
The relationship between spot and forward is as follows:
F = S (1+r1/1+r2)T
where:
F = forward rate
S = spot rate
r1 = simple interest rate of the term currency
r2 = simple interest rate of the base currency
T = tenor (calculated according to the appropriate day count convention)
The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:
F - S = S [(1+r1/1+r2)T - 1] ~ S (e ((r1-r2)T) - 1)
where r1 and r2 are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.
F = S (1+r1/1+r2)T
where:
F = forward rate
S = spot rate
r1 = simple interest rate of the term currency
r2 = simple interest rate of the base currency
T = tenor (calculated according to the appropriate day count convention)
The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:
F - S = S [(1+r1/1+r2)T - 1] ~ S (e ((r1-r2)T) - 1)
where r1 and r2 are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.
Forex Swap
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale, or vice versa, of identical amounts of one currency for another with two different value dates (normally spot to forward).
Structure
A forex swap consists of two legs:
. a spot foreign exchange transaction, and
. a forward foreign exchange transaction.
These two legs are executed simultaneously for the same quantity, and therefore offset each other.
It is also common to trade forward-forward, where both transactions are for (different) forward dates.
Structure
A forex swap consists of two legs:
. a spot foreign exchange transaction, and
. a forward foreign exchange transaction.
These two legs are executed simultaneously for the same quantity, and therefore offset each other.
It is also common to trade forward-forward, where both transactions are for (different) forward dates.
Retail Forex
In financial markets, the retail forex (retail off-exchange currency trading or retail FX) market is a subset of the larger foreign exchange market. This "market has long been plagued by swindlers preying on the gullible," according to The New York Times. Whilst there may be a number of fully regulated, reputable international companies that provide a highly transparent and honest service, it's commonly thought that about 90% of all retail FX traders lose money.
It is now possible to trade cash FX, or forex (short for Foreign Exchange (FX)) or currencies around the clock with hundreds of foreign exchange brokers through trading platforms. The reason that the business is so profitable is because in many cases brokers are taking the opposite side of the trade, and therefore turning client capital directly into broker profit as the average account loses money. Some brokers provide a matching service, charging a commission instead of taking the opposite site of the trade and "netting the spread", as it is referred to within the forex "industry."
Recently forex brokers have become increasingly regulated. Minimum capital requirements of US$20m now apply in the US, as well as stringent requirements now in Germany and the United Kingdom. Switzlerand now requires forex brokers to become a bank before conducting fx brokerage business from Switzerland.[citation needed]
Algorythmic or machine based formula trading has become increasingly popular in the FX market,with a number of popular packages allowing the customer to program his own studies.
The most traded of the "major" currencies is the pair known as the EUR/USD, due to its size, median volatility and relatively low "spread", referring to the difference between the bid and the ask price. This is usually measured in "pips", normally 1/100 of a full point.
According to the October 2008 issue of e-Forex Magazine, the retail FX market is seeing continued explosive growth despite, and perhaps because of, losses in other markets like global equities in 2008.
It is now possible to trade cash FX, or forex (short for Foreign Exchange (FX)) or currencies around the clock with hundreds of foreign exchange brokers through trading platforms. The reason that the business is so profitable is because in many cases brokers are taking the opposite side of the trade, and therefore turning client capital directly into broker profit as the average account loses money. Some brokers provide a matching service, charging a commission instead of taking the opposite site of the trade and "netting the spread", as it is referred to within the forex "industry."
Recently forex brokers have become increasingly regulated. Minimum capital requirements of US$20m now apply in the US, as well as stringent requirements now in Germany and the United Kingdom. Switzlerand now requires forex brokers to become a bank before conducting fx brokerage business from Switzerland.[citation needed]
Algorythmic or machine based formula trading has become increasingly popular in the FX market,with a number of popular packages allowing the customer to program his own studies.
The most traded of the "major" currencies is the pair known as the EUR/USD, due to its size, median volatility and relatively low "spread", referring to the difference between the bid and the ask price. This is usually measured in "pips", normally 1/100 of a full point.
According to the October 2008 issue of e-Forex Magazine, the retail FX market is seeing continued explosive growth despite, and perhaps because of, losses in other markets like global equities in 2008.
Subscribe to:
Posts (Atom)
