FX Option Performance. An Analysis of the Value Delivered by FX Options since the Start of the Market. The Wiley Finance Series

  • ID: 2899270
  • Book
  • 264 Pages
  • John Wiley and Sons Ltd
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Praise for FX Option Performance

′The authors have for the first time uncovered what actually happens to foreign exchange options once they are bought or sold and it can be unexpected. Any students taking a course on derivatives trading or valuation should include this in their reading, and investors or corporations will find valuable information here for their trading and hedging strategies. Highly readable, with figures and data to back up every statement, it is a useful addition to any financial collection.′
Piotr Karasinski, Senior Advisor at the European Bank for Reconstruction and Development

′This new book on FX Options Performance presents valuable insights into which FX vanilla options and their trading strategies would have been worth their money. The authors have conducted a gigantic historic data analysis with spot, rates and smile data ranging back to the origins of the FX options market across several currency pairs and I am pleased to see that they have made their research results available in this book. Both investors and hedgers will benefit from knowing which FX option based strategies would have worked in the past and understand how an options based carry trade tends to influence the performance.′
Uwe Wystup, Managing Director, MathFinance AG, Germany

′This book is written by some of the world′s leading experts on FX options. Anyone who regularly trades FX options will find it full of useful and immediately applicable material.′
John Hull, Maple Financial Professor of Derivatives and Risk Management, Joseph L. Rotman School of Business, University of Toronto

′I commend the authors for their careful study of the difference between the price of an FX option and its average payoff. As such, their study is of immense interest to both practitioners and academics alike.′
Peter Carr, PhD, Global Head of Market Modeling at Morgan Stanley, Executive Director of NYU Courant Masters In Math Finance

′This book is superb and clearly reflects the authors′ mastery of the subject. The exposition is comprehensive, covering contributions from all corners of the subject, from the history and the basics of FX option trading all the way through the latest research in the area. There is no excess verbiage or mathematics: everything is there for a reason. This book defines our state of knowledge on FX options.′
Lucio Sarno, Professor of Finance, Cass Business School, City University London, Research Fellow, Centre for Economic Policy Research

′Jessica James is a story teller. She and her co–authors have written about foreign exchange options like a best–selling thriller, with a unique combination of a superb literary style, comprehensive practical experience and deep intellectual understanding of what actually happens in financial markets. Read this little gem of a book not only to find out why these instruments are persistently mis–valued, but also to appreciate the authors′ gifted writing.′
Carol Alexander, Professor of Finance at the University of Sussex, Co–Editor–in–Chief of the Journal of Banking and Finance

′This book describes the findings of path–breaking empirical research into the actual market worth of Foreign Exchange options and forwards. These findings on cost effective hedging of FX exposures are all the more remarkable in that their authors′ long standing senior experience in leading financial institutions advising institutional clients has been applied to previously open questions critical for investors, rather than for banks, as is nowadays commonly held.′
Professor M.A.H. Dempster, Centre for Financial Research, Statistical Laboratory, University of Cambridge and Cambridge Systems Associates Limited

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About the Authors xi

CHAPTER 1 Introduction 1

1.1 Why Read This Book? 1

1.2 This Book 3

1.3 What Is an FX Option? 3

1.4 Market Participants 5

1.4.1 How Hedgers Can Use This Information 6

1.4.2 How Investors Can Use This Information 7

1.5 History and Size of the FX Option Market 9

1.6 The FX Option Trading Day 14

1.7 Summary 14

References 14

CHAPTER 2 The FX Option Market: How Options Are Traded and What That Implies for Option Value 17

2.1 Introduction 17

2.2 The Basics of Option Pricing 18

2.2.1 The Black–Scholes–Merton Model 18

2.2.2 The Impact of Volatility 20

2.2.3 The Impact of Rate Differentials 21

2.3 How Options Are Traded 22

2.3.1 Two Views of Volatility 23

2.3.2 Static Trading 24

2.3.3 Dynamic Trading 24

2.4 A More Detailed Discussion of Option Trading 26

2.4.1 The Greeks 26

2.5 Summary 31

References 31

CHAPTER 3 It Is All About the Data 33

3.1 Introduction 33

3.2 The Goal: To Price Lots of Options! 34

3.3 Defining a Universe of Currencies 34

3.4 The Data 37

3.4.1 Pricing Model Data Requirements 38

3.4.2 Sourcing the Data 39

3.4.3 Calculation Frequency 40

3.4.4 Currency of Option Notional Amount 41

3.4.5 Spot Market Value 42

3.5 Limitations 43

3.6 Summary 45

References 45

CHAPTER 4 At–the–Money–Forward (ATMF) Options 47

4.1 What Are ATMF Options? 47

4.1.1 How Are ATMF Options Used and Traded? 47

4.1.2 What Is the Fair Price for an ATMF Option? 48

4.2 How Might Mispricings Arise? 50

4.2.1 Can the Forward Rate Be on Average Wrong? 51

4.2.2 Can the Implied Volatility Be on Average Wrong? 52

4.2.3 Simple Example with USDJPY 53

4.3 Results for Straddles for All Currency Pairs 55

4.3.1 Discussion of Results for Straddles 57

4.3.2 A Breakdown of the Results by Currency Pair 62

4.3.3 Drilling Down to Different Time Periods 62

4.3.4 Comparison of Put and Call Options 64

4.4 Have We Found a Trading Strategy? 75

4.5 Summary of Results 76

References 76

CHAPTER 5 Out–of–the–Money (OTM) Options: Do Supposedly Cheap OTM Options Offer Good Value? 77

5.1 Introduction 77

5.2 Price versus Value 78

5.3 The Implied Volatility Surface 79

5.4 Why Do Volatility Surfaces Look Like They Do? 80

5.4.1 Equity Indices 80

5.4.2 Foreign Exchange Markets 83

5.5 Parameterising the Volatility Smile 84

5.6 Measuring Relative Value in ATMF and OTM Foreign Exchange Options 88

5.6.1 The Analysis 89

5.6.2 Option Premium 90

5.6.3 Option Payoff 90

5.6.4 Payoff–to–Premium Ratios 90

5.6.5 Discussion 95

5.6.6 Alternative Measures of OTM Option Worth 96

5.7 Summary 97

Reference 97

CHAPTER 6 G10 vs EM Currency Pairs 99

6.1 Why Consider EM and G10 Options Separately? 99

6.2 How Would EM FX Options Be Used? 99

6.3 Straddle Results 100

6.3.1 Comparison of ATMF Put and Call Options 103

6.3.2 Comparison of OTM Put and Call Options 106

6.3.3 The Effect of Tenor 111

6.4 Hedging with Forwards vs Hedging with Options 113

6.5 Summary of Results 120

CHAPTER 7 Trading Strategies 123

7.1 Introduction 123

7.2 History of the Carry Trade 123

7.3 Theory 124

7.4 G10 Carry Trade Results 125

7.5 EM Carry Trade Results 130

7.6 What Is Going On? 131

7.7 Option Trading Strategies Buying Puts 132

7.8 Option Trading Strategies Selling Calls 136

7.9 Option Trading Strategies Trading Carry with Options 140

7.9.1 Premium and Payoff vs MTM Calculations 144

7.10 Summary of Results 146

References 147

CHAPTER 8 Summary 149

8.1 A Call to Arms 149

8.2 Summary of Results from This Book 150

8.3 Building up a Picture 151

8.3.1 What Does This Mean in Practice? 155

8.4 Final Word 156

Appendix 157

Glossary 241

Index 247

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JESSICA JAMES is Head of the FX Quantitative Solutions team at Commerzbank in London. She was formerly with Citigroup and held a number of FX roles, latterly as Global Head of the Quantitative Investor Solutions Group.

JONATHAN FULLWOOD is a Director in FX Quantitative Solutions at Commerzbank in London. He has also worked in fixed income research and portfolio strategy roles.

PETER BILLINGTON is Global Head of FX Exotic Option Trading at UniCredit in London. Since 1993 he has worked in FX option trading roles for Standard Chartered Bank and BNP Paribas and been Global Head of FX Trading at Commerzbank.

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