FX Options

An FX option gives its buyer the right, but not the obligation, to exchange one currency for another at an agreed rate (the strike) on or before a set date. Currency options work like stock options in principle, but the FX options market has its own conventions: prices are usually quoted in implied volatility, strikes are often specified by delta, and the smile is described by at the money volatility, risk reversals and butterflies. Most FX options trade over the counter between banks and clients, with listed options on exchanges such as CME.

Calls and puts in two currencies#

Every FX option is a call on one currency and a put on the other. A EUR call / USD put gives the right to buy euros and sell dollars at the strike. In EUR/USD terms, this is a call on the pair. See Calls and Puts.

Pricing: Garman Kohlhagen#

FX options are priced with the Garman Kohlhagen model (1983), an adaptation of Black Scholes in which the foreign interest rate plays the role of a dividend yield:

call = S × e^(-r_f T) × N(d1) - K × e^(-r_d T) × N(d2)
d1 = [ln(S/K) + (r_d - r_f + σ²/2) × T] / (σ × √T)
d2 = d1 - σ × √T

• S: spot rate (domestic per foreign)
• r_d, r_f: domestic and foreign interest rates

See Black-Scholes Model.

Market conventions#

Who uses FX options#

• Exporters and importers: buy options to protect against adverse moves while keeping upside, often using collars or zero cost structures.
• Investors: hedge foreign holdings.
• Speculators: take views on direction or volatility around central bank meetings and elections.
• Carry traders: buy puts on high yielding currencies to protect against crashes. See Carry Trades in Forex.

Exotic FX options#

FX is the largest market for exotic options:

• Barrier options: knock in and knock out, very common in corporate hedging. See Barrier Options.
• Digital (binary) options and one touch options. See Binary Options.
• Target redemption forwards (TARFs): structured products that can carry large hidden risks for buyers.

Listed FX options#

CME lists options on its currency futures, and some exchanges list options on spot rates. Listed options offer transparency and central clearing, but most volume remains over the counter. See Currency Futures.

Risks#

• Premium loss for buyers.
• Large losses for sellers in sharp moves, such as the 2015 Swiss franc shock.
• Complex structures can hide leveraged exposure.
• Liquidity in exotic pairs and long tenors.

Frequently asked questions#

What is an FX option?#

A contract giving the right to exchange one currency for another at a set rate on or before a set date.

How are FX options priced?#

With the Garman Kohlhagen model, a version of Black Scholes that uses both domestic and foreign interest rates, and are usually quoted in implied volatility.

What is a risk reversal in FX options?#

The difference between implied volatility of a 25 delta call and a 25 delta put, showing which direction the market is paying more to protect against.

Next, learn exchange traded currency contracts in Currency Futures.