## Resources

FINCAD offers the most transparent solutions in the industry, providing extensive documentation with every product. This is complemented by an extensive library of white papers, articles and case studies.

FX Options

## Introduction

Foreign exchange options are an alternative to forward contracts when hedging an FX exposure because options allow the company to benefit from favorable FX rate movements, while a forward contract locks in the FX rate for a future transaction. Of course this "insurance" from the option is not free, while it costs nothing to enter into a forward transaction.

When pricing foreign exchange options, the underlying is the spot or forward foreign exchange rate.

If we assume that exchange rates follow geometric Brownian motion (same type of stochastic process as a stock), using USD / JPY as the FX rate, the foreign currency (JPY) is analogous to a stock providing a known dividend yield, where the owner of the foreign currency receives a "dividend yield" equal to the risk-free rate in the foreign currency. These and other assumptions allow us to utilize generic option models, such as Black-Scholes, in the valuation of FX options.

## Technical Details

FX options can be confusing and sometimes require a little extra thought because one customer will consider the option a CALL and another will consider the same FX option a PUT. It is always important to understand what the expected payoff is because once the payoff is known the inputs to the option functions will be clear.

As an example, if the strike rate is 1.45 CAD/USD ($1.45 CAD buys$1.00 USD) then the payoff for a long call on USD would look like the illustration below. Remember that a call on USD is the same as a put on CAD, so if the CAD/USD rate rises to 1.50, a 1.45 PUT on CAD is in the money.

Payoff for a Long Call on USD

## Analysis Supported

FINCAD FX options functions can be used for the following:

• Calculate fair value and risk statistics for a European, American or Asian FX option;
• Calculate fair value, risk statistics and risk report of a European FX option with settlement convention;
• Calculate fair value and risk statistics for a European or American exercise single barrier FX option;
• Calculate fair value and risk statistics for a European or American exercise double barrier FX option. The option is a double knock-out barrier option, and the payoff may be vanilla or binary type: initially the holder owns a call or put binary option, but if at any time either barrier is breached, the option is lost or knocked-out;
• Calculate fair value and risk statistics for a binary FX option
• Calculate fair value and risk statistics for a binary barrier FX option. The payoff is a fixed amount of cash if the barrier is breached; otherwise, nothing if the barrier is never breached, and vise versa;
• Calculate fair value and risk statistics for a binary barrier FX option. The payoff is a fixed amount of cash if the barrier is touched and the option is in the money at expiry; otherwise, nothing;
• Calculate fair value and risk statistics for a binary barrier FX option. The payoff is a fixed amount of cash if the barrier is not touched and the option is in the money at expiry; otherwise, nothing.

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## F3 Brochure

Portfolio valuation and risk analytics for multi-asset derivatives and fixed income.

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