Encyclopedic Dictionary of International Finance and Banking Phần 3 potx

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are similar to forward contracts except that they are standardized and traded on the organized

exchanges and the gains and losses on the contracts are settled each day.

See also FOREIGN CURRENCY FUTURES; FOREIGN CURRENCY FUTURES; FOR￾WARD CONTRACTS.

CURRENCY INDEXES

Currency indexes are economic indicators that attempt to measure foreign currencies. Two

popular currency indexes are:

• Federal Reserve Trade-Weighted Dollar: The index reflects the currency units of

more than 50% of the U.S. purchase, principal trading countries.The index mea￾sures the currencies of ten foreign countries: the United Kingdom, Germany, Japan,

Italy, Canada, France, Sweden, Switzerland, Belgium, and the Netherlands. The

index is weighted by each currency’s base exchange rate and then averaged on a

geometric basis. This weighting process indicates relative significance in overseas

markets. The base year was 1973. The index is published by the Federal Reserve

System and is found in its Federal Reserve Bulletin or at various Federal Reserve

Internet sites such as http://woodrow.mpls.frb.fed.us/economy. The MNC

should examine the trend in this index to determine foreign exchange risk exposure

associated with its investment portfolio and financial positions. Also, the Federal

Reserve trade-weighted dollar is the basis for commodity futures on the New York

Cotton Exchange.

• J.P. Morgan Dollar Index: The index measures the value of currency units versus

dollars. The index is a weighted-average of 19 currencies including those of France,

Italy, United Kingdom, Germany, Canada, and Japan. The weighting is based on the

relative significance of the currencies in world markets. The base of 100 was estab￾lished for 1980 through 1982. The index highlights the impact of foreign currency

units in U.S. dollar terms. The MNC can see the effect of foreign currency con￾version on U.S. dollar investment.

See also BRITISH POUND; DEUTSCHE MARK; YEN.

CURRENCY OPTION

Foreign currency options are financial contracts that give the buyer the right, but not the

obligation, to buy (or sell) a specified number of units of foreign currency from the option

seller at a fixed dollar price, up to the option’s expiration date. In return for this right the

buyer pays a premium to the seller of the option. They are similar to foreign currency futures,

in that the contracts are for fixed quantities of currency to be exchanged at a fixed price in

the future. The key difference is that the maturity date for an option is only the last day to

carry out the currency exchange; the option may be “exercised,” that is, presented for currency

exchange, at any time between its issuance and the maturity date, or not at all. Currency

options are used as a hedging tool and for speculative purposes.

EXAMPLE 34

The buyer of a call option on British pounds obtains the right to buy £50,000 at a fixed dollar

price (i.e., the exercise price) at any time during the (typically) three-month life of the option.

The seller of the same option faces a contingent liability in that the seller will have to deliver

the British pounds at any time, if the buyer chooses to exercise the option. The market value of

CURRENCY INDEXES

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an option depends on its exercise price, the remaining time to its expiration, the exchange rate

in the spot market, and expectations about the future exchange rate. An option may sell for a

price near zero or for thousands of dollars, or anywhere in between. Notice that the buyer of a

call option on British pounds may pay a small price to obtain the option but does not have to

exercise the option if the actual exchange rate moves favorably. Thus, an option is superior to a

forward contract having the same maturity and exercise price because it need not be used—and

the cost is just its purchase price. However, the price of the option is generally greater than the

expected cost of the forward contract; so the user of the option pays for the flexibility of the

instrument.

A. Currency Option Terminology

Foreign currency option definitions are as follows.

1. The amount is how much of the underlying foreign currency involved.

2. The seller of the option is referred to as the writer or grantor.

3. A call is an option to buy foreign currency, and a put is an option to sell foreign

currency.

4. The exercise or strike price is the specified exchange rate for the underlying currency

at which the option can be exercised.

• At the money—exercise price equal to the spot price of the underlying currency.

An option that would be profitable if exercised immediately is said to be in the

money.

• In the money—exercise price below the current spot price of the underlying

currency, while in-the-money puts have an exercise price above the current spot

price of the underlying currency.

• Out of the money—exercise price above the current spot price of the underlying

currency, while out-of-the-money puts have an exercise price below the current

spot price of the underlying currency. An option that would not be profitable if

exercised immediately is referred to as out of the money.

5. There are broadly two types of options: American option can be exercised at any

time between the date of writing and the expiration or maturity date and European

option can be exercised only on its expiration date, not before.

6. The premium or option price is the cost of the option, usually paid in advance

by the buyer to the seller. In the over-the-counter market, premiums are quoted

as a percentage of the transaction amount. Premiums on exchange-traded

options are quoted as a dollar (domestic currency) amount per unit of foreign

currency.

B. Foreign Currency Options Markets

Foreign currency options can be purchased or sold in three different types of markets:

1. Options on the physical currency, purchased on the over-the-counter (interbank)

market;

2. Options on the physical currency, purchased on an organized exchange such as the

Philadelphia Stock Exchange; and

3. Options on futures contracts, purchased on the International Monetary Market

(IMM).

CURRENCY OPTION

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B.1. Options on the Over-the-Counter Market

Over-the-counter (OTC) options are most frequently written by banks for U.S. dollars against

British pounds, German marks, Swiss francs, Japanese yen, and Canadian dollars. They are

usually written in round lots of $85 to $10 million in New York and $2 to 83 million in

London. The main advantage of over-the-counter options is that they are tailored to the

specific needs of the firm. Financial institutions are willing to write or buy options that vary

by amount (national principal), strike price, and maturity. Although the over-the-counter

markets were relatively illiquid in the early years, the market has grown to such proportions

that liquidity is now considered quite good. On the other hand, the buyer must assess the

writing bank’s ability to fulfill the option contract. Termed counterparty risk, the financial

risk associated with the counterparty is an increasing issue in international markets. Exchange￾traded options are more the sphere of the financial institutions themselves. A firm wishing

to purchase an option in the over-the-counter market normally places a call to the currency

option desk of a major money center bank, specifies the currencies, maturity, strike rate(s),

and asks for an indication, a bid-offer quote.

B.2. Options on Organized Exchanges

Options on the physical (underlying) currency are traded on a number of organized exchanges

worldwide, including the Philadelphia Stock Exchange (PHLX) and the London International

Financial Futures Exchange (LIFFE). Exchange-traded options are settled through a clear￾inghouse, so that buyers do not deal directly with sellers. The clearinghouse is the counterparty

to every option contract and it guarantees fulfillment. Clearinghouse obligations are in turn

the obligation of all members of the exchange, including a large number of banks. In the

case of the Philadelphia Stock Exchange, clearinghouse services are provided by the Options

Clearing Corporation (OCC).

The Philadelphia Exchange has long been the innovator in exchange-traded options

and has in recent years added a number of unique features to its United Currency Options

Market (UCOM) making exchange-traded options much more flexible—and more com￾petitive—in meeting the needs of corporate clients. UCOM offers a variety of option

products with standardized currency options on eight major currencies and two cross￾rate pairs (non-U.S. dollar), with either American- or European-style pricing. The

exchange also offers customized currency options, in which the user may choose exercise

price, expiration date (up to two years), and premium quotation form (units of currency

or percentage of underlying value). Cross-rate options are also available for the DM/¥

and £/DM. By taking the U.S. dollar out of the equation, cross-rate options allow one

to hedge directly the currency risk that arises in dealing with nondollar currencies.

Contract specifications are shown in Exhibit 21. The PHLX trades both American-style

and European-style currency options. It also trades month-end options (listed as EOM,

or end of month), which ensures the availability of a short-term (at most, a two- or

sometimes three-week) currency option at all times and long-term options, which extend

the available expiration months on PHLX dollar-based and cross-rate contracts providing

for 18- and 24-month European-style options. In 1994, the PHLX introduced a new

option contract, called the Virtual Currency Option, which is settled in U.S. dollars rather

than in the underlying currency.

CURRENCY OPTION

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