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Foreign Exchange Options

In finance, a foreign exchange option (commonly shortened to just FX option) is a derivative 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.

For example a USD/GBP FX option might be specified by a contract allowing the purchaser to exchange £1,000,000 into $2,000,000 on December 31st. In this case the pre-agreed exchange rate, or strike price, is 2USD/GBP or 0.5GBP/USD and the notional is £1,000,000. This type of contract may be called either a dollar call or a sterling put depending on the market convention. If the dollar is stronger than 0.5GBP/USD come December 31st (say at 0.55GBP/USD) then the option will be exercised, making a profit of (2 - 1/0.55)*1,000,000 = $181,818 or £100,000

Valuing FX options: The Garman-Kohlhagen model

As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of a european option on an FX rate is typically calculated by assuming that the rate follows a log-normal process. In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the risk-free interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of foreign currency per unit of domestic currency").

See also

• Foreign Exchange Market
• Currency
• Euro
• Exchange Rate
• Currency Future
• Futures Contract
• Basis Point
• Interest Rate
• Investment

• Summary Measures of the Foreign Exchange Value of the Dollar

• Forex and Commodities Futures and Options. What to know before you trade

Put option
Call option

This article is licensed under the GNU Free Documentation License.
It uses material from the Wikipedia article "Foreign Exchange Options".