An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

20

Additional Option Applications

20.1 CHAPTER OVERVIEW

Previous chapters have looked at option valuation and risk measures as well as key option strategies. In the current chapter these concepts are applied to currency (foreign exchange) and interest rate options as well as to convertible bonds. The chapter explores how currency options can be used to manage foreign exchange exposures. It considers how exchange-traded contracts operate. It outlines how the Black-Scholes option pricing model is commonly adapted to price currency options. The chapter then considers how interest rate options are quoted and traded and how they are used to manage interest rate exposures. Specific products reviewed are caps and ‘caplets’; floors and ‘floorlets’; interest rate collars; options on short-term interest rate futures; and swaptions, which are options to buy or sell interest rate swaps. Trading and hedging applications of these various products are explored. A summary is provided of hedging or trading strategies (using cash or derivative products) that might be implemented for different interest rate forecasts. Finally, the chapter explains the basic structure and applications of convertible bonds (CBs) including convertible arbitrage trades.

20.2 OTC AND EXCHANGE-TRADED CURRENCY OPTIONS

A currency or FX option is the right but not the obligation:

• to exchange two currencies;

• on the expiry date (on or before the expiry date in the case of an American option);

• at a fixed rate of exchange. ...