A comprehensive guide to the world's largest financial market Foreign exchange is the world's largest financial market and continues to grow at a rapid pace. As economies intertwine and currencies fluctuate there is hardly a corporate entity that doesn't need to use options on foreign exchange to hedge risk or increase returns. Moreover, currency options, both vanilla and exotic, are part of standard toolkit of professional portfolio managers and hedge funds. Written by a practitioner with real-world experience in this field, the Third Edition of Options on Foreign Exchange opens with a substantive discussion of the spot and forward foreign exchange market and the mechanics of trading currency options. The Black-Scholes-Merton option-pricing model as applied to currency options is also covered, along with an examination of currency futures options. Throughout the book, author David DeRosa addresses the essential elements of this discipline and prepares you for the various challenges you could face.* Updates new developments in the foreign exchange markets, particularly regarding the volatility surface* Includes expanded coverage of the currency crises and capital controls, electronic trading, forward contracts, exotic options, and more* Employs real-world terminology so you can a firm understanding of this dynamic marketplace The only way to truly succeed in today's foreign exchange market is by becoming more familiar with currency options. The Third Edition of Options on Foreign Exchange will help you achieve this goal and put you in better position to make more profitable decisions in this arena.
Preface xi What's New to This Edition xii Before You Begin xii Acknowledgments xiii CHAPTER 1: Foreign Exchange Basics 1 The Foreign Exchange Market 1 The International Monetary System 6 Spot Foreign Exchange and Market Conventions 11 Foreign Exchange Dealing 14 Interest Parity and Forward Foreign Exchange 21 Departures from Covered Interest Parity in 2007-2008 26 CHAPTER 2: Trading Currency Options 29 The Interbank Currency Option Market 29 Option Basics 31 Listed Options on Actual Foreign Currency 38 Currency Futures Contracts 40 Listed Currency Futures Options 44 CHAPTER 3: Valuation of European Currency Options 47 Arbitrage Theorems 48 Put-Call Parity for European Currency Options 50 The Black-Scholes-Merton Model 52 How Currency Options Trade in the Interbank Market 60 Reflections on the Contribution of Black, Scholes, and Merton 62 CHAPTER 4: European Currency Option Analytics 65 Base-Case Analysis 65 The "Greeks" 66 Special Properties of At-the-Money Forward Options 77 Directional Trading with Currency Options 79 Hedging with Currency Options 86 Appendix 4.1 Derivation of the BSM Deltas 88 CHAPTER 5: Volatility 91 Alternative Meanings of Volatility 91 Some Volatility History 99 Construction of the Volatility Surface 113 The Vanna-Volga Method 115 The Sticky Delta Rule 118 Risk-Neutral Densities 118 Dealing in Currency Options 119 Trading Volatility 121 Mixing Directional and Volatility Trading 124 Appendix 5.1 Vanna-Volga Approximations 125 CHAPTER 6: American Exercise Currency Options 127 Arbitrage Conditions 127 Put-Call Parity for American Currency Options 128 The General Theory of American Currency Option Pricing 131 The Economics of Early Exercise 132 The Binomial Model 136 The Binomial Model for European Currency Options 143 American Currency Options by Approximation 144 Finite Differences Methods 149 CHAPTER 7: Currency Futures Options 159 Currency Futures and Their Relationship to Spot and Forward Exchange Rates 159 Arbitrage and Parity Theorems for Currency Futures Options 167 Black's Model for European Currency Futures Options 174 The Valuation of American Currency Futures Options 178 The Quadratic Approximation Model for Futures Options 180 CHAPTER 8: Barrier and Binary Currency Options 183 Single Barrier Currency Options 185 Double Barrier Knock-Out Currency Options 193 Binary Currency Options 197 Contingent Premium Currency Options 203 Applying Vanna-Volga to Barrier and Binary Options 204 What the Formulas Don't Reveal 205 CHAPTER 9: Advanced Option Models 207 Stochastic Volatility Models 208 The Mixed Jump-Diffusion Process Model 211 Local Volatility Models 213 Stochastic Local Volatility 214 Static Replication of Barrier Options 215 Appendix 9.1: Equations for the Heston Model 231 CHAPTER 10: Non-Barrier Exotic Currency Options 233 Average Rate Currency Options 233 Compound Currency Options 237 Basket Options 241 Quantos Options 242 Comments on Hedging with Non-Barrier Currency Options 250 Appendix 10.1 Monte Carlo Simulation for Arithmetic Mean Average Options 250 Bibliography 253 Index 263
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