FX Option Performance. Peter Billington

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1

See the Appendix for a discussion on the ‘right’ price for an option.

2

It is worth noting that other common uses of these same terms indicate that a technical valuation error has been made, but we are not concerned with that usage here.

3

For a definition of P/L and other terms, please see the Glossary.

4

Between the initial cost of an option and the final payout there is of course a continuous series of values of the contract, which converge to the final amount, be that positive or negative. Thus whether an option has been ‘cheap’ or ‘expensive’ can become apparent as the option nears expiry.

5

The tenor of the option is the time between the start (‘inception’) and payoff date (‘expiry’).

6

Wikipedia – yes, even real researchers use it. Or for a more formal definition see http://assets.isda.org/media/e0f39375/1215b0eb.pdf/.

7

The markets delight in detail; the expiry date will define the payoff of the option but settlement, when cash is transferred, will occur a day or so later, depending on the currency pair.

8

It is worth noting that while we choose to refer to the two currencies in an FX quotation as base and quote, other alternatives are common. We discuss some of these alternatives and FX market conventions in general in the Appendix.

9

When referring to currencies we will use the three-letter ISO codes, so EUR for the euro and USD for the US dollar. A table is given in the Appendix.

10

Short dated contracts in FX usually refer to anything up to 3M tenor. Long dated would be 1–5 years.

11

It is worth a quick note on returns and leverage. The graph gives returns in percent of notional amount. However, this is not the same as capital invested, as no more than a few percent of the notional amount is ever needed or risked. So to make a comparison with this and an equity investment, it is common to specify capital ‘at risk’, which, looking at the graph, might be considered to be 20–30 % of the notional amount. Thus the returns would be multiplied by a factor between 5 and 3 in this case.

12

OTC means Over The Counter, a reference to a liquid secondary market where many market users are willing to trade with each other off-exchange. Because the trades are bilateral, contracts are not limited to standard formats as is the case for exchange-traded products.