payments
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A Foreign Exchange Primer1. Initial exchange of principles$10 millionBorrower
Swap counterpartySfr 16.7 million
$10 million
Bank lender
2. Intermediate flowsreceives interestSwap counterparty
Borrowerpays fixed rate
pays interest
Bank lender
3. Final exchange of principles$10 millionBorrower
Swap counterpartySfr 16.7 million
$10 million
Bank lender
Figure 13.1 The stages in a currency swap
are due to the company’s Eurobond investors: pay dollar coupon payments tied to a presetindex and re-exchange the dollar notional into Swiss francs at maturity.
13.2 INTEREST PAYABLEThus lies the fundamental difference between a currency swap and the classic foreign exchangeswap. During the life of the currency swap, each currency bears an agreed rate of interest, whichis usually paid or received at intervals. Under a foreign exchange swap, no interest is payable
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77
on either currency. Rather, the price at which the currencies will be exchanged at maturitytakes account of the interest differential between the two.Thus, if sterling rates for one year are at 5% and the dollar rates are at 2%, the theoreticalforward exchange rate between the two currencies is 3% less than the spot rate prevailing.Under a one-year currency swap between the two, the rate for the re-exchange at the end ofone year will be the same as that used at the start, but interest will be payable or receivable oneach currency. In the simple case of a one-year swap between two currencies at a ﬁxed rateof interest, the two techniques are little different. Consider, however, a ﬁve-year traditionalforeign exchange swap between dollars and Swiss francs. The forward foreign exchange ratewill represent the compounded interest rate differential between the two currencies and onlytwo cash ﬂows will occur, namely the spot transaction and the forward leg in ﬁve years, at aradically different exchange rate.Under a currency swap between dollars and Swiss francs for ﬁve years, an amount of eachcurrency would be exchanged at the start (determined by the spot rate prevailing), the partyreceiving the francs would pay an agreed interest rate periodically, as would the party receivingthe dollars. At the end of ﬁve years, the same amount of each currency would be re-exchanged.There is no need for the rate of interest applicable to each currency to be on a ﬁxed basis, itcan be a ﬂoating rate tied to Libor, for example. Indeed, the vast majority of currency swapscurrently transacted are between dollars at 6-month Libor and another currency at a ﬁxed rateof interest, payable either bi-annually or annually as agreed between the two parties.
13.3 BENEFITS OF CURRENCY SWAPS13.3.1 FlexibilityCurrency swaps give companies extra ﬂexibility to exploit their comparative advantage in theirrespective borrowing markets. Also, currency swaps allow companies to exploit advantagesacross a matrix of currencies and maturities.
CONCLUDING REMARKSThe currency swap market has become a liquid and cost-effective market for corporate treasurers to achieve long-term currency hedges for their liabilities. Today, one of the most commontransactions in the currency swap market is that related to a capital market debt issue, which isthen swapped in its entirety to another currency that the borrower requires. Also, an interestingapplication of the currency swap has been to generate foreign exchange prices by combiningtwo or more ‘zero-coupon’ swaps against ﬂoating-rate dollars, which cancel out the ﬂoatingrate ﬂows and leave one with an exchange of a given amount of one currency against anotherat a future date, which is precisely similar to a long-term foreign exchange transaction. Undera zero-coupon swap, the ﬁxed rate interest payable/receivable is not paid until maturity and iscompounded at the same time as it is paid.Because of the exchange and re-exchange of notional principle amounts, the currency swapgenerates a larger credit exposure than an interest rate swap.
14Foreign Exchange OptionsThe currency options market shares its origins with the new markets in derivative products,which have blossomed in recent years. They were developed to cope with the rise in volatility in the ﬁnancial markets world wide. In the foreign exchange markets, the dramatic rise(1983–1985) and the subsequent fall (1985–1987) in the dollar caused major problems for central banks, corporate treasurers, and international investors alike. Windfall foreign exchangelosses became enormous for the treasurer who failed to hedge, or who hedged too soon, orwho borrowed money in the wrong currency. The investors in the international bond marketsoon discovered that the risk on their bond positions could appear insigniﬁcant relative to theircurrency exposure. Therefore, currency options were developed, not as another interestingoff-balance-sheet trading vehicle but as an alternative risk management tool to the spot andforward foreign exchange markets. They are a product of currency market volatility and owetheir existence to the demands of foreign exchange users for alternative hedging and exposuremanagement techniques.
14.1 DEFINITIONSA foreign exchange option gives the holder the right, but not the obligation, to buyor sell a certain currency against another, at a certain rate and at/by a certain date inthe future.The most important factor of an option, in comparison to a foreign exchange transaction, is thatthe buyer has the right, but not the obligation, to buy or sell a speciﬁed quantity of a currencyat a speciﬁed rate on or before a speciﬁed date. For this right, the buyer pays a premium to theseller or writer of the currency option, usually at the outset. For currency options, the premiumis often expressed as a percentage of the notional amount covered. The essential characteristicsof a currency option for its owner are those of risk limitation and unlimited proﬁt potential.It is similar to an insurance policy. Instead of an individual paying a premium and insuringa house against ﬁre risk, a company pays a premium to insure itself against adverse foreignexchange risk movements. This premium is the buyer’s maximum cost.The terms used in the options market can be confusing, but the principle terms or jargonused can be summarized as follows.
r The option buyer is called the buyer and the option seller the writer.r A call gives the buyer the right to buy a speciﬁc quantity of a currency at an agreed rate overa given period.
r A put gives the buyer the right to sell a speciﬁc quantity of a currency at an agreed rate overa given period.
r The premium is the price paid for the option. With a currency option this can be expressedin different ways and is usually paid with spot value from the initial deal date.
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r The principle amount is the amount of currency which the buyer can buy or sell.r Exercise is the process by which the option is converted into an underlying foreign exchangecontract.
r The strike price or exercise rate is the exchange rate at which the option may be exercised.r Expiry date is the ﬁnal date on which the option may be exercised.r A European style option can be exercised at any time but the funds will be transferred onthe maturity date. In practice, most European style options are not exercised until the expirydate.r An American style option can be exercised at any time up to and including the expiry datewith the funds being transferred with spot value from exercise.It is important to note that, due to the nature of foreign exchange, all currency options are aput on one currency and a call on another. For example, a dollar call/Swiss franc put gives thebuyer the right to buy dollars and the right to sell Swiss francs.
14.2 EXCHANGE vs OVER-THE-COUNTER OPTIONSForeign exchange options can be traded on an exchange on or in the over-the-counter (OTC)market, i.e. between two parties. Exchange-traded options are standardized contracts with ﬁxedmaturity dates, strike prices and contract sizes, although each exchange has its own contractspeciﬁcations and trading rules. OTC option speciﬁcations are much more ﬂexible as maturity,strike price amount, etc., can be negotiated before dealing.Exchange-traded options can be characterized by as follows:
r Currencies are quoted mainly against dollars although recently some crosses have becomeavailable.
r Strike prices are at ﬁxed intervals and quoted in dollars or cents per unit(s) of currency.r Contract sizes are ﬁxed.r Fixed expiry dates, generally at three-month intervals, e.g. delivery on the third Wednesdayof March, June, September and December.
r Premium is paid up front and on the same day as the transaction.r Options are usually American style.One major advantage of standardized contracts is that the exchange acts as the counterparty toeach trade. Credit risk (the risk of the writer defaulting on the option) is therefore minimizedand anonymity between counterparties can be preserved. It should be noted that currencyoptions on the Chicago Mercantile Exchange (CME) are options on futures rather than optionson the spot currency. Hence, if a call is exercised, the buyer receives a long futures positionrather than a spot position, and the opposite applies to the buyer of a put.Over-the-counter options have the following characteristics:
r Strike rates, contract sizes and maturity are all subject to negotiation. An institution can structure its own option requirements, enabling it, for example, to make cross rate transactions.
r Maturities can run from several hours to ﬁve years.r The buyer has the direct credit risk on the writer.r Only the counterparties directly involved know the price at which the option is dealt.r The premium is normally paid with spot value from the transaction date with delivery of theunderlying instrument also typically with spot value from expiry.
r Options style can be American or European, but the majority are European.
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81
For example, Bank A buys from Bank B a 1.5700 European style sterling call/dollar put on£10 million, with a maturity of six months. Bank A buys the option through the OTC marketfor a premium of $0.02 per £1 principle. In this example:Buyer:Writer (seller):Strike price:Principle amount:Expiry date:Premium:
Bank ABank B1.5700£10 000 0006 months$200 000 (£10 m × $0.02)
14.3 APPLICATION OF FOREIGN EXCHANGE OPTIONSThe users of the option market are widespread and varied, but the main users are organizations whose business involves foreign exchange risk. Options may be a suitable means ofremoving that risk and are an alternative to forward foreign exchange transactions. In general,the exchange-traded options markets will be accessed by the professional market makers andcurrency risk managers. The standardization of options contracts promotes tradability, but thisis at the expense of ﬂexibility.In spite of the fact that options are becoming more and more popular with corporate clients,funds and private individuals, there is still some client resistance to using options to managecurrency exposures. Some clients consider options to be expensive and/or speculative. Whenyou buy an option, the most you can lose is the premium (price paid for the option). Insome cases, options can help to minimize downside risk, while allowing participation in theupside potential. One of the reasons that clients may choose to use an option instead of aforward to manage their downside risk, is this opportunity to participate in the upside proﬁtpotential which is given up with a forward contract. Clients who buy currency options enjoyprotection from any unfavourable exchange rate movements. (This is shown graphically inFigure 14.1.)Companies use currency options to hedge contingent/economic exposures, to hedge anexisting currency exposure, and possibly to proﬁt from currency ﬂuctuations, while funds mayuse options to enhance yield.A simpliﬁed decision tree on when to use options, or the various other products available,can be quite useful. The decision-making process assumes a ﬁrm view of likely future ratemovements, as indecisiveness can only be accommodated by the use of currency options,which can be an expensive solution for many hedging requirements. The more conﬁdent theforecast, the simpler the products needed to satisfy needs. The simpler the product, the cheaperthe cost. If the forecast is conﬁdent that rates will be favourable, then it is best to stay unhedgedor to take out an option with the full conﬁdence that the premium cost will be recovered, asthe option means that any unexpected downturn will be catered for. Similarly, if no change isexpected, then the position should be covered with the cheapest hedge possible. A conﬁdentforecast that rates will be unfavourable would call for a forward contract. An example of anexposure management decision tree is shown as in Figure 14.2.Sometimes a strategy may involve more than one option and some option strategies employmultiple and complex combinations. Certain combinations can yield a low or no-cost optionstrategy by trading off the premium spent on buying an option with the premium earned byselling an option.
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A Foreign Exchange Primer1
Gain3
2
0Premium paid
Loss1. Do nothing: potential loss or gain2. Forward forex contract: no potential loss or gain3. Purchase an option – loss limited to premium paidwhile retaining upside potential
Figure 14.1 Foreign exchange considerations
Do nothingMove favourablyUse currency option
If foreign exchangerates are expected to
Be unchanged frompresent levels
Hedge
Forward foreignexchange contract
Move unfavourablyArbitrage foreignexchange and moneymarkets
Figure 14.2 Exposure management decision tree
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83
Hence, the purchase of a currency option may help by limiting the downside currencyﬂuctuation risk while retaining the upside potential, by providing unlimited potential for gain,by providing a hedge for a contingent risk, and by enabling planning with more certainty.On the other hand, selling a currency option may assist in providing immediate income frompremium received and provides ﬂexibility when used with other tools as part of an exchangerate strategy.In general, the applications of foreign exchange options can be summarized as follows.
r To cover foreign exchange exposure:– on existing exposure– on contingent exposure– against a budget rate– as disaster insurancer To speculate:– on the direction of spot– on a volatile or quiet market– on the timing of spot movement– on changing interest rate differentialsr To lock in proﬁt:– as an investment:in a speculative asset orto alleviate loan costs orto improve deposit yields– as a funding tool:to generate a cash ﬂow (short position) orto transfer cash to another entity– as a tax management tool:to transfer proﬁt and loss over time.For a hedger, in terms of exchange rate risk management, currency options can be used toguarantee a budget rate for a transaction. By purchasing a call (the right to buy) the maximumcost can be ﬁxed for a purchase and by purchasing a put (the right to sell) the minimum sizeof a receipt can be ﬁxed. The purchase of the option involves paying a premium but gives thebuyer the full protection against unfavourable moves while retaining full potential to proﬁtshould rates subsequently move beneﬁcially. This contrasts with a forward contract, whichlocks the hedger into a ﬁxed exchange rate, where no premium is payable but no beneﬁt canbe taken from subsequent favourable moves.In the case of trading, to assume risk in order to make a proﬁt, traders use options to beneﬁtfrom both directional views and/or changes in volatility. (This allows proﬁt to be made from theexpectation that volatility will either increase or decrease over a period of time.) For example,in order to take a directional view, an options trader might feel strongly that the dollar willstrengthen against the Swiss franc in the next three months from its current level of $/Sfr 1.66.The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strikeprice of 1.6835, with expiry in three months’ time.The trader has two choices: to hold the option to expiry, and if the spot rate has risen to, forexample, $/Sfr 1.73, the trader would exercise his right to buy dollars and sell Swiss francsat 1.6835, and hence, make money. If the spot rate is below $/Sfr 1.6835 at expiry, then themaximum loss is limited to the premium paid for the option. Alternatively, if the spot rate
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A Foreign Exchange Primer
Table 14.1 Forex options versus forex forwardsOptions
Forwards
Right but not the obligation to buy or sell a currency
Obligation to buy or sell a currency
Premium payable
No premium payable
Wide range of strike prices
Only one forward rate for a particular date
Retains unlimited proﬁt potential while limitingdownside risk
Eliminates the upside potential as well as thedownside risk
Flexible delivery date of currency (can buy anoption for a longer period than necessary)
Fixed delivery date of currency
Table 14.2 Forex options versus forex open positionsOption
Open position
Right but no obligation to buy or sell a currency
No obligation to buy or sell a currency
Premium payable
No premium payable
Retains unlimited proﬁt potential while limitingdownside risk
Proﬁt and loss potential unlimited
Flexible delivery date of currency (can buy anoption for a longer period than needed)
Indeﬁnite delivery date of currency
rises, say one month after the trader has purchased the option, the trader could choose to sellthe option back. By doing this, the trader will recoup both the time value and intrinsic valueof the option.
14.4 ALTERNATIVES TO FOREIGN EXCHANGE OPTIONSQuite often there really seems to be little point in paying a premium for an option whena foreign exchange forward would sufﬁce, but the beneﬁts of an option really do have tobe considered. Hence, the difference between an OTC foreign exchange option and foreignexchange forward can be seen in Table 14.1, and the differences between buying an OTC foreignexchange option and leaving the position unhedged, i.e. leaving the position open, can be seen inTable 14.2.
14.5 PARTIES AND THE RISKS INVOLVEDTwo parties are involved in foreign exchange options: the option buyer and the option seller(writer), and Figure 14.3 outlines a risk proﬁle for each. The option buyer has the right todemand fulﬁlment of the option contract. The owner can exercise the option. The option buyerpays a premium for that right. The option seller (writer) grants the right and receives a premiumfor accepting the obligation to fulﬁl the option contract, if the buyer demands.As in spot and forward foreign exchange contracts, there are risks involved in currencyoptions. If the option expires worthless (i.e. is not exercised), then there is no real credit risk.
Foreign Exchange Options
Financial risk
Profitpotential
Credit risk
Option buyer
Limited topremium paid
Unlimited
Creditworthiness ofoption seller
Option seller(writer)
Unlimited
Limited topremiumearned
Settlement riskif option isexercised
85
Figure 14.3 Risk proﬁle of option buyer/seller
If it is exercised, there is transaction-related risk that is similar to the risk on a spot settlement.Because an option buyer enjoys the dual beneﬁts of insurance and upside potential, the optionseller/writer is subject to a greater degree of market/price risk than when it enters into a forwardcontract. As for country risk, it is similar to that for forwards and swaps.
14.6 USERS OF FOREIGN EXCHANGE OPTIONSAs Figure 14.3 shows, there is one very important factor to remember regarding currencyoptions: for the buyer of an option, the maximum risk is limited to the premium paid, butfor the option seller, the maximum proﬁt is limited to the premium received and the seller ispotentially exposed to unlimited losses. Additionally, because of the credit risk involved whenwriting options, there are typically fewer restrictions on those wishing to buy options than onthose wishing to sell.Writing options on exchanges tends to be simpler as the credit risks are controlled by amargin system. The margin is a small percentage of the value of the contract, which must bedeposited to cover losses up to a certain limit. The margin is usually adjusted on each tradingday and, on occasions, more frequently to take account of market movements. However, thegreater ﬂexibility available in the OTC market allows some of the credit difﬁculties to bepursued and overcome. Participants in the foreign exchange currency options market include:
r Banks – who provide a service for their clients, to manage their own foreign exchange risk,and in order to take a directional and/or volatility view.
r Supranationals and sovereigns – all issuers of debt in foreign currencies will have exchangerate exposure, which must be managed.
r Multinational companies – multinationals and their subsidiaries will have funds and crossborder transactions in several currencies and so will be subject to foreign exchange risk.
r Importers and exporters – any company that imports or exports goods to a foreign countrywill have exposure to ﬂuctuations in exchange rates.
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r Investors in foreign currency securities – investors in foreign securities will be exposed toﬂuctuations in the currency in which the securities are denominated.
r High net worth individuals – such individuals may use exchange-traded currency optionsfor speculation on exchange rates because of the gearing they offer.For example, a British-based company exports consumer goods to several countries. Currently,the company has contracted to supply 10 million dollars worth of goods to America and expectsto receive payment in three months’ time, in dollars. The company believes that the dollar willappreciate against sterling over the next three months.There are several alternative strategies. The company can:(1) leave the future cash ﬂow unhedged in the belief that the exchange rate will move in theirfavour;(2) enter into a forward contract to sell dollars and buy sterling in three months’ time;(3) purchase a 3-month sterling call option (the right to buy sterling and sell dollars).Possible results:1. If the exchange rate does move in the company’s favour, then the company will receive awindfall proﬁt on its long dollar position. However, this strategy is very dangerous becauseif the exchange rate moves contrary to the company’s expectations, its sterling proﬁts willbe reduced and could become a loss as its costs are ﬁxed in sterling.2. If the company enters into a forward contract, it is locking in an exchange rate for the supplydeal. This gives the company protection against a dollar depreciation but does not allow itto take any proﬁt from a dollar appreciation, which is contrary to its expectations for theexchange rate.3. If the company purchases a sterling call option, this will require the company to pay outa premium upfront. However, it will guarantee the company a minimum exchange rate forthe supply contract. It allows the company to indulge its expectations that the dollar willappreciate from current levels as, should this expected appreciation occur, the companyis free to abandon the option and transact in the market at the more favourable exchangerate.If the company decides to purchase a currency option, it could buy a 3-month option, aEuropean-style sterling call/dollar put option, with a strike price of £/$1.75 (that is, the rightto buy sterling and sell dollars at a rate of £/$1.75). Assume the cost of the option is 1.74%of the sterling amount, i.e. £99 428.57 ($10 000 000 divided by 1.75 equals £5 714 285.71 ×1.74%).The outcome at maturity is:Sterling amount fromSpot rate
Option exercised/not exercised:
1.85001.80001.70001.6500
ExercisedExercisedNot exercised – buy spotNot exercised – buy spot
deal (less premium)£5 614 857.14£5 614 857.14£5 782 924.37£5 961 177.49
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14.7 HEDGING VERSUS SPECULATIONIn viewing whether an option should be viewed as a hedge or as a speculative instrument, ahedger’s main concern is the value of the option at maturity. For this reason, any ﬂuctuationof the option’s intrinsic value during its life is important, but any change in its time value islargely irrelevant.Intrinsic value is the advantage to the holder of the option of the strike rate over theforward outright rate.Also, as the option is itself a hedge, no further hedging is required and therefore there are noextra costs.The option premium for a hedger represents:Option premium = intrinsic value + time valueFor example, if the forward outright rate of the dollar against Swiss francs is 1.6000, then fora dollar call (right to buy), Swiss franc put (right to sell) option, with a strike of 1.5700, theintrinsic value of the option would be 0.0300 dollar against Swiss francs. For a dollar put (rightto sell), Swiss franc call (right to buy) option, with a strike of 1.5700, then the intrinsic valueof the option is 0.0000 dollar against Swiss francs.Time value is a mathematical function of implied volatility, time to maturity, interestrate differentials, spot and the strike of an option.Time value represents the additional value of an option due to the opportunity for the intrinsicvalue of the option to increase.For a trader/speculator, the option premium represents the expected net presentvalue of the cost of delta hedging the option.A trader’s main concern is the value of the option whenever it is marked to market. For thisreason, any ﬂuctuation in the intrinsic value of the option is important, but any change in thetime value will also be signiﬁcant. If the trader, at any time, decides to hedge or partially hedgethe option, extra transaction costs may be incurred, which might affect the overall return.
14.8 OPTION THEORY14.8.1 DeltaDelta is the change in premium per change in the underlying. Technically, the underlying isthe forward outright rate, but as the option-pricing model assumes constant interest rates, thisis often calculated using spot. For example, if an option has a delta of 25 and spot moved 100basis points, then the option price gain/loss would be 25 basis points. For this reason, delta issometimes thought of as representing the ‘spot sensitive’ amount of the option.
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An option’s price sensitivity to price changes in the underlying instrument is knownas its delta.Delta can also be thought of as the estimated probability of exercise of the option. As theoption-pricing model assumes an outcome proﬁle based around the forward outright rate, anat-the-money option has a delta of 50%. It falls for out-of-the-money options and increasesfor in-the-money options, but the change is non-linear, in that it changes much faster whenthe option is close-to-the-money.An option is said to be delta-hedged if a position has been taken in the underlying inproportion to its delta. For example, if one is short a call option on an underlying with a facevalue of $1 000 000 and a delta of 0.25, a long position of $250 000 in the underlying will leaveone delta-neutral with no exposure to changes in the price of the underlying, but only if theseare inﬁnitesimally small.The delta of an option is altered by changes in the price of the underlying and by its volatility,time to expiry, and interest rates. Hence, the delta hedge must be rebalanced frequently. Thisis known as delta-neutral hedging.14.8.2 GammaGamma is the rate of change in an option’s delta for a one-unit change in theunderlying.Gamma is the change in delta per change in the underlying and is important because the optionmodel assumes that delta hedging is performed on a continuous basis. In practice, however,this is not possible as the market gaps and the net amounts requiring further hedging would betoo small to make it worth while. The gapping effect that has to be dealt with in hedging anoption gives the risk proportional to the gamma of the option.An option’s gamma is at its greatest when an option is at-the-money and decreases as theprice of the underlying moves further away from the strike price. Therefore, gamma is U-shapedand is also greater for short-term options than for long-term options.14.8.3 VolatilityIt is a statistical function of the movement of an exchange rate. It measures the speedof movement within an exchange rate band, rather than the width of that band.In essence, volatility is a measure of the variability (but not the direction) of the price of theunderlying instrument, essentially the chances of an option being exercised. It is deﬁned as theannualized standard deviation of the natural log of the ratio of two successive prices.Historical volatility is a measure of the standard deviation of the underlying instrument over a past period. Implied volatility is the volatility implied in the price of an option. All things being equal, higher volatility will lead to higher option prices. In traditional
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Black–Scholes models, volatility is assumed to be constant over the life of an option. Sincetraders mainly trade volatility, this is clearly unrealistic. New techniques have been developedto cope with volatility’s variability. The best known are stochastic volatility, Arch and Garch.Actual volatility is the actual volatility that occurs during the life of an option. It is the difference between the actual volatility experienced during delta hedging and the implied volatilityused to price an option at the outset, which determines if a trader makes or loses money onthat option.14.8.4 Time Decay (Theta)Time decay is the effect of time passing on an option’s value.Theta is the depreciation of the time value element of the premium, that is, it measures theeffect on an option’s price of a one-day decrease in the time to expiration. The more the marketand strike prices diverge, the less effect theta has on an option’s price.Obviously, if you are the holder of an option, this effect will diminish the value of the optionover time, but if you are the seller (the writer) of the option, the effect will be in your favour,as the option will cost less to purchase. Theta is non-linear, meaning that its value decreasesfaster the closer the option is to maturity. Positive gamma is generally associated with negativetheta, and vice versa.14.8.5 American versus EuropeanIn circumstance where the option enables the purchase of a currency that yields a higher returnthan the currency that is given up in payment, these early exercise features have value, but insuch cases, they are more expensive that their European-style counterparts. Examples wherethis is the case include currency options in which the call currency interest rate exceeds or isclose to the put currency interest rate.American-style option – an option a purchaser may exercise for early value at anytime over the life of the option up to and including its expiration date.European-style option – an option where the purchaser has the right to exercise onlyat expiration.Hence, there is a price difference between the two styles of option, but only sometimes. Thedifference in price occurs because there is a difference in the interest rates that each currencyattracts. With American options, the intrinsic value is priced against the spot or the forwardoutright price, whichever is the most advantageous. This is because the American option canbe exercised for spot value at any time during its life. If the call currency (right to buy) of theoption has a higher interest rate than the put currency (right to sell), there will be an advantagein calculating the intrinsic value against spot rather than against the forward outright rate.Therefore, the main risk of the writer of the American option is that at some point in time,if the option is so far in-the-money that there is negligible time value remaining, the holder
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may exercise early. This would mean that the writer would incur the differential interest costof borrowing the higher interest rate currency and lending the lower interest rate currency. Ifthis happens, the