While currency options are regarded as the best hedging instrument in any foreign exchange trades, it would be more interesting to know about what goes into deciding on the price of these options. Pricing of the options is grossly influenced by many factors, micro and macro. While these factors may or may not be related directly with the option, a writer of an option has to consider them all while pricing an option. Lets walk through few factors as listed below.
1. Price of the underlying asset/security
In case of FX options, the price of the underlying currency is a most important factor while determining the price of the option. This price is termed as S0.
2. Interest Rates
The rate of interest implies the interest that an investor would pay on the cost of borrowing. This rate is supposed to be risk-free. For example, if an investor borrows $1 million from the market to invest in forex options and he is paying an interest at the rate of 15%, the risk-free interest rate is 0.15, which is termed as r.
3. Time to expiry
This is the effective time left to the expiry of the contract. Lets suppose an option contract has a validity of three months and the buyer wishes to exercise it after 2 months, then the time left till expiry is One Month. This is termed as T.
4. Margin amount requirement
If the option is uncovered, the seller of the option can demand a margin money deposit from the buyer. This is one more important factor while determining the price of the option.
Forex markets are highly volatile and the trading volumes deviate much than expected in cases of extreme volatility. While volatility may be the reason for the option prices to increase or decrease, too much volatility can tumble the market. Volatility is termed as s.
6. Tax Rules in Option trading
Currency movements are extremely volatile and many times may not last for more than couple of minutes. Traders take different positions and quickly wind up their positions within short time. This is known as day trading. Options trades can give good short-term returns, which may further attract tax as prescribed by the regulatory body/Government.
7. Strike / Exercise Price of the Option
Strike price is the price at which the option can be exercised, hence known as the exercise price. Lets see example of 2 call options on USD/GBP, one with the strike price of 1.5 USD per GBP and another is 1.25 USD per GBP. The holder of the first option can buy 1 GBP @ 1.5 USD and the second holder can buy it for $1.25 USD. Therefore the second call option has a higher value than the first one.
For valuation of options, the binomial model & Black-Scholes model are highly used. Black-Scholes model is supposed to be a more comprehensive one than the former. Pricing of the options always has great efforts and analysis put in, therefore making options a viable hedging tool than any other derivative.