PROGRAMME ON CURRENCY OPTIONS

20-Aug-10

Vikram Murarka

Anindya Banerjee

by

• What drives USD/INR.

• What drives FX options…Underlying, Volatility & Interest Rates

• Trading of volatility

• Options for directional trading

• Options for ranged markets.

• Arbitrage in NSE FX options.

• Neutralise directional bias

• Option sensitivity

CONTENTS

India's BOT and Rupee

30

35

40

45

50

55

Jul-95

Jan-9

6Jul-96

Jan-9

7Jul-97

Jan-9

8Jul-98

Jan-9

9Jul-99

Jan-0

0Jul-00

Jan-0

1Jul-01

Jan-0

2Jul-02

Jan-0

3Jul-03

Jan-0

4Jul-04

Jan-0

5Jul-05

Jan-0

6Jul-06

Jan-0

7Jul-07

Jan-0

8Jul-08

Jan-0

9Jul-09

Jan-1

0Jul-10

-14000

-12000

-10000

-8000

-6000

-4000

-2000

0

USDINR Mthly

BOT - 4mth MA, RHS

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Factors affecting USD/INR

Long term factors: Current Account and Capital account flows.

Correlation between Rupee and Sensex

30

32

3436

38

40

42

44

4648

50

52

54

Jan-9

3Jul-93

Jan-9

4Jul-94

Jan-9

5Jul-95

Jan-9

6Jul-96

Jan-9

7Jul-97

Jan-9

8Jul-98

Jan-9

9Jul-99

Jan-0

0Jul-00

Jan-0

1Jul-01

Jan-0

2Jul-02

Jan-0

3Jul-03

Jan-0

4Jul-04

Jan-0

5Jul-05

Jan-0

6Jul-06

Jan-0

7Jul-07

Jan-0

8Jul-08

Jan-0

9Jul-09

Jan-1

0Jul-10

1500

3500

5500

7500

9500

11500

13500

15500

17500

19500

USDINR MthlySensex Mthly

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Increase in Current Account

deficit �increase in Demand

for Dollars � rise in USD-INR

Has not been dominant factor till now. What about the future?

Increase in Capital Account

surplus �increase in Supply of

Dollars � fall in USD-INR

Factors affecting USD/INR

Short-term Factors:

- Stock market.

- Risk aversion to emerging markets.

- Inter-relationship between USDINR and other Asian currencies.

- Inter-relationship between USDINR and global major currencies.

- RBI intervention.

Correlation between

USD-INR and USD-KRW

• Option basics: Call & Put option, European option, strike price,money-ness or likelihood of expiring “in the money”, expiry date, delivery date, futures price.

• Option price /premium = Intrinsic value (tangible)+ extrinsic value (expected).

USD/INR call option of August 2010, strike 46, trading @ 0.58 INR. Forward rate is 46.37.

Option premium (0.58) = Intrinsic Value (0.37)+ Extrinsic Value (0.21).

• Factors that drive an option price:

Price of USD/INR, Time to expiration, Volatility, Interest rate differential, Intrinsic Value.

• Buyer bets on small probability of large move, Seller bets on large probability of small move

INTRODUCTION

•Volatility = Sudden-ness + Size of currency movements ( Fear premium)

ON VOLATILITY

• Two types of Volatility: Historical and Implied

• Historicals are calculated statistically from historical prices

Exist largely in theory, seldom used in practice.

Lagging indicator

• Implieds are back-calculated from the prevailing option prices and fed back to get new prices. Are leading indicator, reflect market’s anticipation of future movement.

Close correlation between Spot

(underlying) and Vols.

Vols fall alongwith fall in Spot

Vols rise alongwith rise in Spot

Falls in Spot have been gradual.

Rise in Spot has been sudden. This

is reflected in the Volatility.

Correlation between Spot and Vols

6

8

10

12

14

16

18

20

23-D

ec-0

8

28-J

an-0

9

25-F

eb-0

9

26-M

ar-

09

23-A

pr-

09

25-M

ay-0

9

23-J

un-0

9

21-J

ul-09

19-A

ug-0

9

18-S

ep-0

9

19-O

ct-

09

17-N

ov-0

9

15-D

ec-0

9

15-J

an-1

0

16-F

eb-1

0

19-M

ar-

10

20-A

pr-

10

19-M

ay-1

0

17-J

un-1

0

15-J

ul-10

13-A

ug-1

0

44

45

46

47

48

49

50

51

52

53

3M Vol

USDINR Close

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Correlation between Spot and Vols

6

8

10

12

14

16

18

20

23-D

ec-0

8

28-J

an-0

9

25-F

eb-0

9

26-M

ar-

09

23-A

pr-

09

25-M

ay-0

9

23-J

un-0

9

21-J

ul-09

19-A

ug-0

9

18-S

ep-0

9

19-O

ct-

09

17-N

ov-0

9

15-D

ec-0

9

15-J

an-1

0

16-F

eb-1

0

19-M

ar-

10

20-A

pr-

10

19-M

ay-1

0

17-J

un-1

0

15-J

ul-10

13-A

ug-1

0

44

45

46

47

48

49

50

51

52

53

3M Vol

USDINR Close

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Interest Rates & Option Prices

PROFITING FROM VOLATILITY…involves figuring out whether or not the price will hit the

Strike, and in how much time

MAKING MONEY FROM VOLS

BASICBuy / Sell Call / Put Strike I / A / O Cost

Buy Call 46.34 ATM 3796

Buy Put 46.34 ATM 3796

Total Cost 7592

Underlying View Volatile, in either directon

Max Risk Limited to Cost paid

Max Return Limited after a point

Characteristic 2 legged option

Name Straddle

MAKING MONEY FROM VOLS

INTERMEDIATEBuy / Sell Call / Put Strike I / A / O Cost

Buy Call 46.34 ATM 3796

Buy Call 46.8 OTM 2102

Sell Call 46.00 ITM -5684

Total cost 214

Underlying View Volatile with an upward bias

Max Risk Limited

Max Return Unlimited on the upside

Characteristic leveraged

Name Short Call Ladder

PROFITING FROM DIRECTIONAL BETS…

Hoping your view is right, not really losing if it is not!

PROFITING FROM DIRECTIONAL BETS

BASICBuy / Sell Call / Put Strike I / A / O Cost

Buy Call 46.34 ATM 3796

Underlying View Bullish on USDINR

Max Risk Limited to Cost paid

Max Return Unlimited

Characteristic One single option

Name As Plain Vanilla as they come

PROFITING FROM DIRECTIONAL BETS

INTERMEDIATEBuy / Sell Call / Put Strike I / A / O Cost

Buy Call 46.34 ATM 3796

Sell Call 47.34 OTM -559

Total Cost 3237

Underlying View Bullish, but only upto a point

Max Risk Limited to Cost paid

Max Return Limited after a point

Characteristic 2 legged option

Name Bull Spread

PROFITING FROM DIRECTIONAL BETS

ADVANCEDBuy / Sell Call / Put Strike I / A / O Cost

Sell Put 46.50 ITM -4165

Buy Put 46.00 OTM 4628

Buy Put 46.00 OTM 4628

Total Cost 5091

Underlying View Large downmove.

Max Risk Limited

Max Return Unlimited on the downside

Characteristic Leveraged, 1X2

Name Put Back Spread

PROFITING FROM RANGED MARKETS…

Make money when no one else can

PROFITING IN RANGED MARKETS

PROFITING IN RANGED MARKETS

BASICBuy / Sell Call / Put Strike I / A / O Cost

Sell Call 47.00 OTM -1014

Sell Put 45.68 OTM -970

Total Cost -1984

Underlying View Ranged market

Max Risk Unlimited

Max Return Limited to premium collected

Characteristic 2 legged option

Name Strangle

PROFITING IN RANGED MARKETS

INTERMEDIATEBuy / Sell Call / Put Strike I / A / O Cost

Sell Call 46.40 OTM -3289

Buy Call 46.75 OTM 2145

Sell Put 46.00 OTM -1891

Buy Put 45.50 OTM 1072

Total cost -1963

Underlying View Ranged market

Max Risk large but limited

Max Return Limited to premium collected

Characteristic 4 Legged option

Name Iron Condor

PROFITING IN RANGED MARKETS

ADVANCEDBuy / Sell Call / Put Strike I / A / O Cost

Buy Call 46.00 ITM 5684

Sell Call 46.76 OTM -1671

Sell Call 46.76 OTM -1671

Total cost 2342

Underlying View Ranged with bearish bias

Max Risk Unlimited

Max Return More than premium collected

Characteristic leveraged 1x2

Name Call Ratio Spread

ARBITRAGE: RISKLESS PROFITS

• Arbitrage relates to taking advantage of mis-pricing in USD/INR options. Frequency of mis-pricing is high in markets where liquidity is still not abundant. Even liquid option markets like NSE equity options do exhibit mis-pricing from time to time.

• How to capitalise on mis-pricing of options?

- Triangle strategy: based on put-call parity.

• Triangle strategy: Suppose…

USD/INR 46.00 Aug Call is quoting 0.64.

USD/INR 46.00 Aug Put is quoting 0.24

USD/INR Futures for Aug is quoting 46.34

Difference between Call and Put premium = INR 0.40

No arbitrage spread level = (46.34-46.00)= INR 0.34

Risk-less profit = INR ((0.40-0.34)*1,000,000)= INR 60,000.

• Trade: Sell 46 Aug Call, buy 46 Aug Put, Buy USD/INR futures. Qty= 1 million USD.

ARBITRAGE: RISKLESS PROFITS

• Box Spread: Bull-bear spread trade.

• Box spread strategy: Suppose…USD/INR 46.00 Aug Call is quoting 0.40USD/INR 46.50 Aug call is quoting 0.20USD/INR Futures for Aug is quoting 46USD/INR 46.00 Aug Put is quoting 0.38USD/INR 46.5 Aug Put is quoting 0.78Cost of a bull spread 46/46.5 = INR 0.2Cost of bear spread 46/46.5 = INR 0.4Total cost of the bull and bear spread = INR 0.6No arbitrage cost should have been = (46.5-46.00)= INR 0.5Risk-less profit = INR ((0.6-0.5)*1,000,000)= INR 1,00,000.

• Trade: Sell 46 Aug Call, buy 46.5 Aug call, Buy 46 Aug put and sell 46.5 Aug put

• Qty= 1 million USD.

CAN I MAKE MONEY WITHOUT BETTING ON DIRECTION?

• How to be neutral on direction?

Hedge the delta on your option portfolio.

• How to hedge delta of option portfolio?

Portfolio:

Long 10 contracts of 46 August put @ 2062.56. Delta = (-) USD 3540.

In order to neutralise delta, we have to buy 3540 USD @ 46.20.

Post delta hedging the option portfolio is for the moment would not be affected from a upward or downward movement in the USD/INR.

• When do we make our portfolio delta neutral?

- When we are looking to trade other Greeks viz., Gamma, Theta, Vega.

- Want to minimize directional impact on portfolio.

• Option gives us the flexibility of making money without having to always bet on market direction.

Delta is change in Option Price due to change in Spot. It is not exactly, but is taken to be the chance of the Option expiring In the Money

OPTION GREEKS

• What are option Greeks?

Option Greeks are set of factor sensitivities used for measuringrisk exposures related to options.

• Delta, Gamma, Theta, Vega, Rho.

KEY INTER-RELATIONS

BETWEEN GREEKS

• Delta vs. money-ness (ATM, ITM or OTM) : In the money options (ITM) have higher delta than out of the money options (OTM).

• Gamma, Vega & theta vs. money-ness : At the money options have the highest Gamma, Theta and Vega. All three decline as theoption moves in or out of money.

• Gamma vs. Time : Gamma increases as time to expiry declines.

• Theta vs. Time : Theta increases as time to expiry declines.

• Vega vs. Time : Vega decreases as time to expiry declines.

• Delta vs. Volatility: Delta of an ITM declines and OTM increases.

http://montegodata.co.uk/Consult/Garman/garman.htm

PROGRAMME ON CURRENCY OPTIONS

20-Aug-10

Thank You!www.kshitij.com

info@kshitij.com

033-24892010 /12

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