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INTRODUCTION

A currency option is no different from a stock option

except that the underlying asset is foreign

exchange. The basic premises remain the same: the

buyer of option has the right but no obligation

to enter into a contract with the seller. Therefore the

buyer of a currency option has the right, to his

advantage, to enter into the specified contract

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TERMINOLOGY OF CURRENCY

OPTIONS Call Option:- A call option will have intrinsic

value only when the spot price is above the strike price.

Put Option:- A put option will have

intrinsic value only when the spot price is below the strikeprice.

Intrinsic Value Of The Option:- Intrinsic

value is simply the difference between the spot price and the

strike price.

Time Value Of The Option:- When the price of a call or put

option is greater than its intrinsic value, it is because of its

time value.

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Strike Price/ Exercise Price:- The price at which aspecific derivative contract can be exercised. Strike prices

is mostly used to describe stock and index options, inwhich strike prices are fixed in the contract. For calloptions, the strike price is where the security can bebought (up to the expiration date), while for put optionsthe strike price is the price at which shares can be sold.

Maturity / Expiry Date:- The date on which anoption expires and after that date the option can notbe exercised.

American Option:- An option that can be exercised

anytime during its life. European Option:- An option that can only be

exercised only after maturity.

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Hedging

Hedging means reducing or controlling risk. This is done bytaking a position in the futures market that is opposite tothe one in the physical market with the objective of

reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cashposition due to changes in price levels will be countered bychanges in the value of a futures position. For instance, awheat farmer can sell wheat futures to protect the value of

his crop prior to harvest. If there is a fall in price, the loss inthe cash market position will be countered by a gain infutures position

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Valuation Of Options

Because the values ofoption contracts depend on a

number of different variables in addition to the value of the

underlying asset, they are complex to value. There are

many pricing models in use, although all essentiallyincorporate the concepts ofrational pricing

, Moneyness

,

Option time value and Put-call parity

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Determinants Of Valuation Of

Currency Option The Spot Exchange Rate.

The Strike Or Exercise Price.

Time To Maturity. Home Currency Risk Free Interest Rate.

Foreign Currency Risk Free Interest Rate.

Volatility Of The Spot Exchange Rate.