FX Option Performance (eBook)

An Analysis of the Value Delivered by FX Options since the Start of the Market

Jessica James, Jonathan Fullwood, Peter Billington (Autoren)

eBook Download: EPUB

2015
John Wiley & Sons (Verlag)
978-1-118-79327-5 (ISBN)

Infos

Get the little known – yet crucial – facts about FX options

Daily turnover in FX options is an estimated U.S. $ 207 billion, but many fundamental facts about this huge and liquid market are generally unknown. FX Option Performance provides the information practitioners need to be more effective in the market, with detailed, specific guidance.

This book is a unique and practical guide to option trading, with the courage to report how much these contracts have really made or lost. Breaking free from the typical focus on theories and generalities, this book gets specific – travelling back in history to show exactly how options performed in different markets and thereby helping investors and hedgers alike make more informed decisions. Not overly technical, the rigorous approach remains accessible to anyone with an interest in the area, showing investors where to look for value and helping corporations hedge their FX exposures. FX Option Performance begins with a quick and practical introduction to the FX option market, then provides specific advice toward structures, performance, rate fluctuation, and trading strategies.

• Examine the historical payoffs to the most popular and liquidly traded options
• Learn which options are overvalued and which are undervalued
• Discover surprising, generally unpublished facts about emerging markets
• Examine systemic option trading strategies to find what works and what doesn't

On average, do options result in profit, loss, or breaking even? How can corporations more cost-effectively hedge their exposure to emerging markets? Are cheap out-of-the-money options worth it?

Autor

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.

Inhalt

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

Textauszug

CHAPTER 1
Introduction

1.1 WHY READ THIS BOOK?

Let's be honest, there is no shortage of books on Foreign Exchange (FX) options. There are plenty of places, online and on paper, where you can read about how to value FX options and associated derivatives. You can learn about the history of the market and how different valuation models work. Regular surveys will inform you about the size and liquidity of this vast market, and who trades it.

This is not what this book is about. This is about what happens to an option once it is bought or sold. It is about whether the owner of an option had cause to be happy with their purchase. It is about whether FX options deliver value to their buyers.

In the financial markets, there is huge and detailed effort made to value contracts accurately at the start of their lives. Some decades ago this work was begun in earnest when Black and Scholes published their famous paper [1]. Perhaps indeed we could say it started in 1900 when Bachelier derived a very similar model [2] though this was not followed up on. But, in general, quantitative researchers in the markets and in universities spend long hours to devise ways of correctly valuing complex contingent deals under sets of assumptions which make the mathematics possible.

But are these assumptions right, i.e. over time, do they turn out to have been correct? Bizarrely, they do not have to have been ‘correct’ to continue to be used; later in the book we will give some detailed examples of assumptions that turn out to be manifestly incorrect. For an option, we can say that in an efficient (‘correctly priced’) market, on average, we would expect an option to pay back the money it cost in the first place – less costs, of course.1 In this book we will use terms like ‘mispriced’ or ‘misvalued’ to indicate that the average payoff of the option is significantly different from the average premium paid to own the option.2

That this is not always the case may be surprising. But that options can be systematically ‘cheap’ or ‘expensive’ throughout the history of the market, depending on their precise nature, is even more surprising, and should be of significant interest to many different areas of the finance community.

Why is this not widely known? In part it is simply the focus of the market participants. Most trading desks will operate on a daily mark to market P/L with drawdown and stop-loss limits.3 Another way of putting this is that they will want to make money all or most days, with limited risk. So the timescale and nature of a trading desk dictates that the price of a contract ‘now’ is the focus of the market. Further, depending on the hedging strategy and how the option is traded, different end results can be seen. So pricing the contract ‘now’ is in many ways simpler than trying to model an option's performance. Later, we will discuss in detail how a desk manages its portfolio of options to make money, but we may summarise it now by saying that, ideally, deals are done and hedged so that a small but almost riskless profit is locked in almost immediately. After that, the combination of the deal and its offsetting hedges should be almost immune to market movements – so a systematic tendency for deals to be cheap or expensive over time may well not be noticed on a trading desk, as long as they can be hedged at a profit. The situation is complicated by the fact that a perfect hedge is rarely available, combined with the fact that a trading desk may want to have a ‘position’ – a sensitivity to market movements – when they believe that certain moves are likely to occur.

But the other reason that the long-term mispricing of parts of the FX option markets is not well known is that FX options are a young market! Before one can say that a contract is generally cheap or expensive, one needs to observe it under a variety of circumstances. To say that 12M options bought in 2006, when market confidence was high and volatility low, were cheap because they paid out large sums in 2007, when confidence was greatly shaken and volatilities had begun a very sharp rise, would be to look at a particular case which does not represent the generality of market conditions. It is only really now, with widely available option data available going back to the 1990s, that we can say we have information available for a wide variety of market regimes, and importantly, the transitions between these regimes. We will discuss exactly what data are needed and available in the next chapter, but for now we may say that for most liquid currencies there will be perhaps 20 years of daily data available, with longer time series or higher frequencies available in some cases.

So, we are now in a position to say whether FX options have performed well or badly for their buyers and sellers. We can take a day in the past, collect all the data needed to calculate the cost of the option and look ahead to the payoff of the option at expiry to compare the two. We can tell, on average and for different time periods, whether the options have had the correct price.

If they have not had the correct price – and the fact that there is a book being written on the subject implies that this has been the case at least some of the time! – then the situation becomes much more interesting. Why did the market appear to be inefficient? Was there a good reason? Is it connected to the way options are used, the way they are hedged, differences in demand and supply? We will show that indeed, in different ways, the payoff and the cost of the options have differed significantly throughout the history of the market, and moreover these differences have been systematic, repeated in different currency pairs and market regimes.4

1.2 THIS BOOK

The book is laid out in increasing order of complexity. We give a brief history of the market and describe how options are valued – this will cover simple widely used valuation techniques; it is not our intention to go deeply into the details of exotic option pricing. Then we set the scene by introducing the available dataset and discussing the way that the market operates. We next introduce the first set of comparisons, looking at payoff vs cost or premium for options of different tenors.5 We then move on to look at different types of option: puts, calls, options which pay out at different levels or strikes, and options on emerging market currencies, which present particular features and may have less data available. Finally we examine whether some of the anomalies we see are predictable and whether it is possible to use some market indicators to buy and sell options in a dynamic fashion to improve the protection they provide or to deliver value.

Perhaps we need to say at this point – before the reader gets too far – that there will be no magical profit-making trading strategy found in these pages. Though the market can consistently show features which seem to indicate that it lacks efficiency, inevitably they are not those which lead to a fast buck and early retirement for those who happen upon them. That is not to say that the information here may not be useful to those looking for trading strategies. At the very least it could prevent them from reinventing the wheel, show them where opportunity may lie and where they may be wasting their time. But the authors confess freely that they have not yet discovered the Holy Grail of risk-free yet profitable trading. And if they do, they may not be publishing it in a book…

1.3 WHAT IS AN FX OPTION?

Before we discuss which market participants can use this information, we should define more precisely what kind of contract we are talking about. Foreign Exchange (FX) options are contracts whose payoff depends upon the values of FX rates, and they are widely used financial instruments.

Let's look at a definition from a popular website…6

A foreign-exchange option is a derivative financial instrument that gives the owner 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 future date.

The price or cost of this right is called the premium, by analogy with the insurance market, and it is usually (depending on the tenor and the market at the time) a few percent of the insured amount (notional amount). The specified future date is called the expiry or expiry date.7 The payoff profile at expiry of the simplest type of option is shown schematically in Figure 1.1.

FIGURE 1.1 Payoff profile at expiry for a call option

The figure shows the payoff received by the holder of an at-the-money-forward (ATMF) call option on an FX rate. This means that the strike of the option is the forward rate, and the option is the right to buy the base currency, or, in other words, an option to buy the FX rate.8 In other markets such as commodities and equities it is obvious what the call or put is applied to but in FX more clarity is needed. For instance a call option associated with the currency pair USDJPY could be a call on USD (and thereby a put on JPY) or a call on JPY (and therefore a put on USD). As different currency pairs have different conventions it is always best to clarify the exact details before trading. A put option would be the right to sell the base currency, or FX rate. We will...

Produkt-Details

• Erscheint lt. Verlag: 23.4.2015
• Reihe/Serie: The Wiley Finance Series
• Reihe/Serie: Wiley Finance Series
• Reihe/Serie: Wiley Finance Series
• Sprache: englisch
• Themenwelt: Recht / Steuern ► Wirtschaftsrecht
• Themenwelt: Wirtschaft ► Betriebswirtschaft / Management ► Finanzierung
• Schlagworte: Commerzbank • Currency trading • Finance & Investments • Finanz- u. Anlagewesen • Finanzwesen • fundamental FX options • FX option market • FX Option Performance: An Analysis of the Value Delivered by FX Options Since the Start of the Market • FX options analysis • FX options effectiveness • FX options guide • FX options myths • FX options performance • FX options profitability • FX options reference • FX options strategy • FX options trading • FX options truths • FX Quantitative Solutions • historical FX options • Jessica James • Jonathan Fullwood • Peter Billington
• ISBN-10: 1-118-79327-7 / 1118793277
• ISBN-13: 978-1-118-79327-5 / 9781118793275