Handbook of Finance: Financial Markets and Instruments

Chapter 66. Introduction to Foreign Exchange Options

SHANI SHAMAH

Consultant, E J Consultants

Foreign Exchange Options 702

Abstract: The currency options market shares its origins with the new markets in derivative products. They were developed to cope with the rise in volatility in the financial markets worldwide. In the foreign exchange markets, the dramatic rise (1983 to 1985) and the subsequent fall (1985 to 1987) in the dollar caused major problems for central banks, corporate treasurers, and international investors alike. Windfall foreign exchange losses became enormous for the treasurer who failed to hedge, or who hedged too soon, or who borrowed money in the wrong currency. The investor in the international bond market soon discovered that the risk on their bond position could appear insignificant relative to their currency exposure. Therefore, currency options were developed, not as another interesting off-balance-sheet trading vehicle but as an alternative risk management tool to the spot and forward foreign exchange markets. They are a product of currency market volatility and owe their existence to the demands of foreign exchange users for alternative hedging and exposure management techniques.

Keywords: premium, option writer, call, put, exercise, strike price, European-style option, American-style option, exchange-traded, over-the-counter (OTC), expiry, contract size, spot value, hedge, volatility, spot rate, option buyer, option seller, margin, intrinsic value, time value, ...