Foreign exchange options can be traded on an exchange on or in the over-the-counter (OTC) market, i.e. between two parties. Exchange-traded options are standardized contracts with fixed maturity dates, strike prices and contract sizes, although each exchange has its own contract specifications and trading rules. OTC option specifications are much more flexible as maturity, strike price amount, etc., can be negotiated before dealing.
Exchange-traded options can be characterized by as follows:
- Currencies are quoted mainly against dollars although recently some crosses have become available.
- Strike prices are at fixed intervals and quoted in dollars or cents per unit(s) of currency.
- Contract sizes are fixed.
- Fixed expiry dates, generally at three-month intervals, e.g. delivery on the thirdWednesday of March, June, September and December.
- Premium is paid up front and on the same day as the transaction.
- Options are usually American style.
One major advantage of standardized contracts is that the exchange acts as the counterparty to each trade. Credit risk (the risk of the writer defaulting on the option) is therefore minimized and anonymity between counterparties can be preserved. It should be noted that currency options on the Chicago Mercantile Exchange (CME) are options on futures rather than options on the spot currency. Hence, if a call is exercised, the buyer receives a long futures position rather than a spot position, and the opposite applies to the buyer of a put.
Over-the-counter options have the following characteristics:
- Strike rates, contract sizes and maturity are all subject to negotiation. An institution can structure its own option requirements, enabling it, for example, to make cross rate transactions.
- Maturities can run from several hours to five years.
- The buyer has the direct credit risk on the writer.
- Only the counterparties directly involved know the price at which the option is dealt.
- The premium is normally paid with spot value from the transaction date with delivery of the underlying instrument also typically with spot value from expiry.
- Options style can be American or European, but the majority are European.
For example, Bank A buys from Bank B a 1.5700 European style sterling call/dollar put on £10 million, with a maturity of six months. Bank A buys the option through the OTC market for a premium of $0.02 per £1 principle. In this example:
Buyer: Bank A
Writer (seller): Bank B
Strike price: 1.5700
Principle amount: £10 000 000
Expiry date: 6 months
Premium: $200 000 (£10 m × $0.02)
Source:A Foreign Exchange Primer
