OPTIONS are among the most well-known types of derivative products. For corporate users, foreign exchange options are among the most commonly used derivatives products. Currency options can offer insurance against unfavourable currency movements and can fix funding costs by eliminating exchange rate risk. Although they are not yet available on the Hong Kong Futures Exchange, banks can tailor currency options for clients to suit their particular exposures. Exchange-traded options can remove counter-party risk from the currency position. Options are contracts to buy or sell an underlying commodity - in the case of foreign exchange options, a currency - at a pre-set price by a pre-set deadline. They are divided into put and call. Buying a call option grants the right, not the obligation, to buy the underlying asset, while buying a put is just the opposite: it conveys the right, not the obligation, to sell it. Since options can be sold and bought, opposing positions can be taken, using both calls and puts. However, selling a call option is not the same as buying a put. The seller of a call has a potential obligation to sell the underlying asset. This obligation only kicks in if the option holder exercises his right to buy. Similarly, the seller of a put option has a potential obligation to buy the underlying asset if the option holder exercises. Buying an option is known as a long position, while selling is known as going short. The pre-set exercise price is also called the strike price and is fixed for the life of a standard option. The deadline for exercise of the option is called the expiry date. The maximum buyers of options can lose, if the market moves against them, is the price paid for their option. At the same time, the potential profit is unlimited. Sellers, on the other hand, have their profit limited to the amount they receive for their options, while their potential for loss is unlimited. In currencies, as with other instruments, options mirror positions in the underlying assets, while granting some insurance to buyers. The most they stand to lose is their initial investment. When an options trade is made, the exercise price and time to expiry are already known. The big unknown variable is how the underlying commodity, in this case the currency, is going to move during the option's life. The higher the volatility of the underlying asset, the greater the opportunity value for the option buyer, because there is a greater chance that the option will be in-the-money (and lead to a profit) by its expiration date. The reverse is true for the option seller. For a call option, in the money means the value of the underlying asset at expiry has a higher market value than the strike price. The reverse applies to puts. An option has intrinsic value if it is in the money, but its price will almost always have another ingredient: time value. This is because anything can happen in the future and, the longer there is until expiry, the greater the chance of a favourable movement in the underlying commodity. Time value is also dependent on volatility, with higher volatility leading to greater risk of adverse movements and more risk of adverse movement. Swiss Bank Corp has given an actual example of the use of foreign exchange options in its Introduction to Foreign Exchange Options. A trader bullish on the US dollar against the deutschemark could go long on the US dollar in the forward market, but that includes the risk of unlimited losses if the dollar falls against the mark. So, the trader buys a US dollar call option but which one? There are choices of strike (exercise) prices which are in the money, at the money and out of the money. Swiss Bank Corp said: 'In order to make this decision, he will consider the up-front premium [price] payable, the break-even point [where the gains begin] and the leverage of a given strike.' Higher leverage can be obtained by buying an out-of-the-money strike. These are cheaper because the underlying commodity has to move to bring them into the money. There is a trade-off in the break-even point; the buyer of an in-the-money call option pays proportionally more premium up front but has a lower break-even point because of the more favourable strike price. For example, if the forward dollar is at 1.6541 marks to the dollar and the one-year US dollar call cost 0.0572 marks per US dollar, the break-even point would be at 1.7572 (adding the premium to the strike price). With the in-the-money 1.6000 US dollar call, the break-even point would be 1.7040 (strike price plus 0.1040 premium).
