Pricing Currency Options

mccw74

Newbie
8 0
To anyone who trades currency options,

I have been trading FX with IG Index for the last year and I note that they have introduced currency options so I thought I have a look at them with the view of hedging my spot positions.

However, when pricing up the options with the black scholes model what interest rate do I need to use? Say for a call option on the £/$, do I use the UK or US interest rate?

Thanks in advance.
 

Robertral

Well-known member
446 4
mccw74 said:
To anyone who trades currency options,

I have been trading FX with IG Index for the last year and I note that they have introduced currency options so I thought I have a look at them with the view of hedging my spot positions.

However, when pricing up the options with the black scholes model what interest rate do I need to use? Say for a call option on the £/$, do I use the UK or US interest rate?

Thanks in advance.

Simply replace the dividend yield, q, with the foreign risk free rate, r_f
 

mccw74

Newbie
8 0
Robertral said:
Simply replace the dividend yield, q, with the foreign risk free rate, r_f

Thanks Robert.

Here is the online currency options calculator that I am using.

http://www2.sjsu.edu/faculty/watkins/exchoptvb.htm

What value do use to plug into the volatility box? There are other online calculators that allow you to work out the implied volatility of an option by re-arranging the equation, but this requres inputting the option price that you want to check whether it is over or underpriced so surely this can't be the value you input. I'm confused. :(
 

Robertral

Well-known member
446 4
mccw74 said:
Thanks Robert.

Here is the online currency options calculator that I am using.

http://www2.sjsu.edu/faculty/watkins/exchoptvb.htm

What value do use to plug into the volatility box? There are other online calculators that allow you to work out the implied volatility of an option by re-arranging the equation, but this requres inputting the option price that you want to check whether it is over or underpriced so surely this can't be the value you input. I'm confused. :(

There are many different methods to see if an FX option is over/under valued...one method is using a heat map (z-scores).......
What are you trying to do exactly???? if you think vol is going to be 13% and the market is pricing the options at 12% then the market looks cheap...this is relative......
Are you trying to evaluate if the market is over/under valued???
Or are you trying to arb between companies????
Tell me what you are trying to do and I will help
 

mccw74

Newbie
8 0
Robertral said:
There are many different methods to see if an FX option is over/under valued...one method is using a heat map (z-scores).......
What are you trying to do exactly???? if you think vol is going to be 13% and the market is pricing the options at 12% then the market looks cheap...this is relative......
Are you trying to evaluate if the market is over/under valued???
Or are you trying to arb between companies????
Tell me what you are trying to do and I will help

I was reading that you need to be careful about buying overpriced options hence the need to price them up. Is that a too simplistic approach? i.e buy them when they're cheap and sell them when they're high. Obviously in combination with market timing.
 

Robertral

Well-known member
446 4
mccw74 said:
I was reading that you need to be careful about buying overpriced options hence the need to price them up. Is that a too simplistic approach? i.e buy them when they're cheap and sell them when they're high. Obviously in combination with market timing.

well everyone looks to buy low vol and sell high vol
two ways to do what u want:

i) use your own estimate of the vol (GARCH or whatever)...drawback is there will be errors
ii) use a heat map (z-scores)

there are other ways but I;m not too sure about them....
 

Chrissy T

Junior member
34 0
Robert,

If you have a minute please could you explain what a heat map (z-scores) is? I use BS pricing model with my own inputs of implied vol to give me the options prices on the vol/ skew curve then job around theo... Just interested to see if I can integrate this into my approach, or use it in other ways in the future..

Thanks,

Chris
 

Robertral

Well-known member
446 4
Chrissy T said:
Robert,

If you have a minute please could you explain what a heat map (z-scores) is? I use BS pricing model with my own inputs of implied vol to give me the options prices on the vol/ skew curve then job around theo... Just interested to see if I can integrate this into my approach, or use it in other ways in the future..

Thanks,

Chris

they indicate if a value is rich, cheap or neutral on a historical basis

z = (current value - mean of period) / std

do this for various strikes and maturities and u will generate a heat map.....i.e have rich (red), netural (green), cheap (blue)
 

Robertral

Well-known member
446 4
Chrissy T said:
Robert,

If you have a minute please could you explain what a heat map (z-scores) is? I use BS pricing model with my own inputs of implied vol to give me the options prices on the vol/ skew curve then job around theo... Just interested to see if I can integrate this into my approach, or use it in other ways in the future..

Thanks,

Chris

they indicate if a value is rich, cheap or neutral on a historical basis

z = (current value - mean of period) / std

do this for various strikes and maturities and u will generate a heat map.....i.e have rich (red), netural (green), cheap (blue)
 

Chrissy T

Junior member
34 0
Robertral said:
they indicate if a value is rich, cheap or neutral on a historical basis

z = (current value - mean of period) / std

do this for various strikes and maturities and u will generate a heat map.....i.e have rich (red), netural (green), cheap (blue)

Thanks Robert... used similar models for engineering at uni .... am going to try to apply this to Interest rate options
 
 
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