BMGT446: Currency Options

option

gives the holder the right, but not the obligation, to buy or sell a a given quantity of an asset in the future, at prices agreed upon today

exercising the option

buying or selling the underlying asset via the option

exercise or strike price

stated price paid or received

long

buyer of the option

writer (short)

seller of an option

option premium

price of the option contract that must be paid upfront by the option buyer to the option seller

European option

can be exercised only at maturity or expiration date of contract, but American option can be exercised any time during contract

time value

difference between the option premium and the option’s intrinsic value is nonnegative and is sometime referred to as the option’s time value

binomial option-pricing model

gives an exact pricing formula for a European call or put

risk-neutral probabilities

are probabilities of possible future outcomes that have been adjusted for risk

general principle of option pricing

get the expected value in a risk neutral world, then discount the expected value using the risk-free rate

risk-neutral probability (q)

here is the probability that makes the expected future spot rate equal to the forward rate

hedge ratio

the size of the position on the underlying asset that will offset the risk associated with an option contract

-long the option → short the underlying asset at the expiration date to eliminate the risk

-short the option → long the underlying asset at the expiration date to eliminate the risk