FX Options Trading and Risk Management Paiboon Peeraparp Feb. 2010 1
Risk Uncertainties for the good and worse
scenariosMarket RiskOperational RiskCounterparty Risk
Financial Assets Stock , Bonds Currencies Commodities
Non-Financial Assets Weather Inflation Earth Quake
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Instruments Forwards
Contracts to buy or sell financial assets at predetermined price and time
Linear payout No initial cost
Options Rights to buy or sell financial asset at
predetermined price (strike price) and time Non-Linear payout Premium charged
4
Participants
Hedgers Want to reduce risk
Speculators Seek more risk for profit
Brokers / Dealers Commission and Trading
Regulators/ Exchanges Supervise and Control
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FX (Foreign Exchange) Market
Over the counter Trade 24 hours Active both
spot/forwards/options Banks act as dealers
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FX Banks Trade to accommodate clients
Make profit by bid/offer spread Absorb the risk from clients Offer delivery service Other Commission Fees
Trade on their own positions Trade on their views (buy low and sell high)
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Forwards Valuation (1)An Electronic manufacturer needs to hedge
gold price for their manufacturing in 1 years.
A dealer will need toT= 0 1. borrow $ 1,000 at interest rate of 4% annually2. buy gold spot at $ 1,000T = 1 yr1. repay loan 10,40 (principal + interest) 2. Charge this customer at $ 1,040Valuation by replication , F = Sert
In FX and commodities market, we call F-S swap points
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We call the last construction as the arbitrage pricing by replicate the cash flow of the forward.
If F is not Sert but G G > F , sell G, borrow to buy gold spot cost = F G < F , buy G, sell gold spot and lend to receive =
F The construction is working well for
underlying that is economical to warehouse it.
For the others, it typically follows the mean reverting process.
Forwards Valuation (1)
Physical / Paper Hedging Physical Hedging
Deliver goods against cash No basis risk
Paper Hedging Cash settlement between contract rate
and market rate at maturity Market rate reference has to be
agreed on the contracted date. Some basis risk incurred
Option Characteristics (1)P/L of Call Option Strike at 34.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
30.00 31.00 32.00 33.00 34.00 35.00 36.00 37.00
P/LTime value
Intrinsic Value
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C-Ke-rt > 0, we call the option is in the moneyC-Ke-rt = 0, we call the option is at the moneyC-Ke-rt < 0, we call the option is out of the money
Option Characteristics (2)For a plain vanilla option
An option buyer needs to pay a premium. An option buyer has unlimited gain. An option seller has earned the premium
but face unlimited risk. This is the zero-sum game.
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P/L Diagram An importer needs to pay USD vs. THB for 1 year.
P/L
Rate
P/L
Rate
P/L
Rate
+ =
P/L
Rate
P/L
Rate
P/L
Rate
+ =
Underlying
Option
ForwardUnderlying
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Options Details
Buyer/Seller Put/Call Notional Amount European/ American Strike Time to Maturity Premium
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Option Premium (1)
Normally charged in percentage of notional amount
Paid on spot date Depends on (S,σ,r,t,K) can be
represented by V= BS(S,σ,r,t,K) if the underlying follows BS model.
Option Premium (2)
BS(S,σ,r,t,K)σ1> σ2 then BS(S,σ1,r,t,K) > BS(S,σ2,r,t,K) t1> t2 then BS(S,σ,r,t1,K) > BS(S,σ,r,t2,K)r1> r2 then BS(S,σ,r1,t,K) > BS(S,σ,r2,t,K)
In reality, the call and put are traded with the market demand supply.
From the equation C,P = BS(S,σ,r,t,K), we solve for σ and call it implied volatility.
The is another realized volatility is the ∑actual realized volatility.
Put/Call Parity
P/L
Rate
Call option for buyer
P/L
Rate
Call option for seller
P/L
Rate
Put option for seller
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P/L
Rate
+ =
F = C – PF = S-Ke-rt
C-P = S-Ke-rt
K
Options
Path Independence Plain Vanilla European Digital
Path Dependence Barriers American Digital Asian Etc.
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Combination of Options (1) Risk Reversal
Buy Call option Sell Put option
1. View that the market is going up (Strikes are not unique).
2. Can do it as the zero cost.3. If do it conversely, the buyer of this structure
view the market is going down.
+ =
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Combination of Options (2) Straddle
Butterfly Spread
Buy Call option Buy Put option
+
+
=
=
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Buy Call & Put option Sell Straddle
Create a suitable risk and reward profile
Finance the premium Better spread for the banks
Combination of Options (3)
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Risk Reward AnalysisCombine your underlying with the options and see how much you get and how much you lose.
More risk more return
+
+
=
=
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Underlying
Underlying
Structuring
Dual Currency Deposit is the most popular product that combine sale of option and a normal deposit .
For example, the structure give the buyer of this deposit at normal deposit rate + r % annually. But in case the underlying asset has gone lower the strike, the buyer will receive underlying asset instead of deposit amount.
This structure will work when the interest rates are low and volatilities are high. 24
FX Option Quotation in FX market (1)
1.Quotes are in terms of BS Model implied volatilities rather than on option price directly.
2.Quotes are provided at a fixed BS delta rather than a fixed strike.
3.However implied volatilities are not tradeable assets, we need to settle in structures.
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FX Option Quotation in FX market (2)
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Standard Quotation in the FX markets1 Straddle
- A straddle is the sum of call and put at the same strike at the money forward2 Risk Reversal (RR)
- A RR is on the long call and short put at the same delta3 Butterfly
- A Butterfly is the half of the sum of the long call and put and short Straddle.
BBA FX Option Quotation
GBP/USDSpot Rate Option Volatility
25 Delta Risk Reversal 25 Delta Strangle
Date: 1
Month3
Month6
Month1
Year1
Month3
Month1
Year1
Month3
Month1
Year
2-Jan-08 1.9795 9.80 9.80 9.43 9.25 -0.82 -0.79 -0.38 0.23 0.32 0.39
3-Jan-08 1.9732 9.73 9.73 9.48 9.25 -0.61 -0.59 -0.62 0.26 0.33 0.39
4-Jan-08 1.9754 9.45 9.45 9.38 9.20 -1.20 -1.22 -1.30 0.29 0.33 0.39
7-Jan-08 1.9725 9.55 9.55 9.23 9.18 -1.14 -1.18 -0.83 0.27 0.32 0.39
For 3 months (Vatm = 9.8)VC25d-VP25d = -0.79((VC25d+VP25d)/2)-Vatm = 0.32Solve above equationVC25d = 9.725 , VP25d = 10.045
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Volatility Smile
Volatility Smile
9.50
9.60
9.70
9.80
9.90
10.00
10.10
25d 50d 25dStrike
Implied Vo
l
Volatility Sm ile
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Volatility Surface (3)
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• Implies volatilities are steepest for the shorter expirations and shallower for long expiration.
• Lower strike and higher strikes has higher volatilities than the ATM. implied volatilities.
• Implied volatilities tend to rise fast and decline slowly.
• Implied volatility is usually greater than recent historical volatility.
Smile Modeling
In the BS Model the stock’s volatilities are constant, independent of stock price and future time and in consequence (S,t,K,T) = ∑ σ
In local volatility models, the stock realized volatility is allowed to vary as a function of time and stock price. we may write the evolution of stock price as dS/S = µ(S,t)dt + σ(S,t)dZ
We firstly match the σ(S,t) with (S,t,K,T) ∑and this can be done in principle. The problem is to calibrate the σ(S,t) to match with the characteristic of the pattern of the smile
A bank has a lot of fx options outstanding in the book.
They manage overall risk by look into the change of option price given change in one parameter.
Each dealer is limited by the total amount of risk in his book.
Bank Options Hedging
The Greek
A Taylor Expansion:
...)( 221 ScrccSctcc SSrSt
),,,( trSc A call option depends on many parameters:
thetatc
delta
Scvega
c rho
rcgamma
SScA dealer try to keep all parameter hedged except the one they want to take the view.
Dynamic Hedging (1)Set C(S,t) be the option call priceFrom Taylor series expansion
Assume ∆S = ∑S√∆t (∆S)2 = ∑2S2∆tC(S+∆S,t+∆t) = C(S,t)+∂C/∂t ∆t+∂C/∂S ∆S + ∂2C/∂S2 (∆S)2/2
+ …For a fixed t, and define Γ = ∂2C/∂S2
Consider C(S+∆S,t) = C(S,t)+∂C/∂S ∆S + Γ(∆S)2/2 + …
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Dynamic Hedging (2)We like to create a hedged portfolioDefine θ = ∂C/∂t C(S+∆S,t+∆t) = C(S,t)+θ∆t+∂C/∂S ∆S + Γ(∆S)2/2
dP&L = C(S+∆S,t+∆t) - C(S,t) - ∂C/∂S ∆S = θ∆t+ Γ(∆S)2/2Suppose r=0, the hedge portfolio has the same return as riskless portfolio θ∆t + Γ(∆S)2/2 = 0 or θ∆t + Γ/2 ∑2S2∆t = 0 or θ + Γ/2 ∑2S2 = 0
Step by step hedging
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Time Option Value
Stock Value Cash Value Net Position
t C - ∂C/∂S S (∂C/∂S S)-C 0
t+dt C+dC - ∂C/∂S (S+dS)
((∂C/∂S S)-C) (1+rdt)
C+dC - ∂C/∂S (S+dS)+ ((∂C/∂S S)-C) (1+rdt)
Dynamic Hedging (3)dP&L =[C+dC - ∂C/∂S (S+dS)]+ ((∂C/∂S S)-C) (1+rdt)
=dC- ∂C/∂S dS –r(C- ∂C/∂S S)dt
Using Ito’s Lemma for dC we obtain
= θdt+ ∂C/∂S dS +1/2ΓS2σ2dt- ∂C/∂S dS –r(C-∂C/∂S S)dt = [θ+ 1/2ΓS2σ2-r∂C/∂S-rC]dt
By Black-Scholes equation with σ = ∑
θ+ 1/2ΓS2∑2-r∂C/∂S-rC = 0
dP&L = 1/2 ΓS2(σ2-∑2)dt
Real World HedgingA Taylor Expansion:
...)( 221 ScrccSctcc SSrSt
Daily P/L = Delta P/L + Gamma P/l + Theta P/L
= ∂C/∂S (∆S) + 1/2Γ (∆S) 2 + θ (Δt)•The dealer job is to design a option book with the risk that he feel comfortable with.•For a delta hedged position Gamma and Theta have the opposite signs•For a long call or put, Gamma is positive and Theta is negative.•For a short call or put, the situation is reversed.
European Call Option Price
8 8.5 9 9.5 10 10.5 11 11.5 120
0.5
1
1.5
2
2.5
Price
S8 8.5 9 9.5 10 10.5 11 11.5 12
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
S
Delta
European Call Option Delta
8 8.5 9 9.5 10 10.5 11 11.5 120
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
0.5
S
Gamma
European Call Option Gamma
European Call Option Theta
(K=10, T=0.2, r=0.05, =0.2)
8 8.5 9 9.5 10 10.5 11 11.5 12-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
S
Theta
Option Sensitivities