9.3 Derivatives markets

l	Both calls and puts are more expensive the further away the exercise date is. This simply reects the greater risk involved for the writer associated with more distant delivery dates.

l	No one was prepared to write call or put options for December at a strike price of $1.850; options were only available for March 2007 (over 8 months ahead) at a strike price of $1.840.

l

Premiums were generally high, the lowest being on put options for September at 1.88 cents per pound. This was because the foreign exchange market had been very volatile for some time andbecause the spot exchange rate at the close of the foreign exchange market on that day had been £1 $1.8464. Thus, someone able to buy dollars at 1.820 would have been able to make an immediate prot of over 2 cents to the dollar (that is, call options at 1.820, 1.830 and 1.840 were all in-the-money).

We can also see that market feeling on balance was that the dollar was likely to stay

at around $1.85 in the near future since both calls and puts for September were both

priced at 2.99 cents per pound. That is, writers thought that there was an equal chance

that calls and puts would be protable. Given the premium, call options at 1.850 would

have become protable if the dollar were to fall to above £1 $1.88; puts would have

become protable had the dollar risen to below £1 $1.82.

Source: Financial Times, 15 June 2006

Intrinsic value of an option:The prot available from immediately exercising an option.

Where the value of the right granted by the option is equal to the market value of the

underlying instrument (the intrinsic value is zero), the option is said to be at-the-money.

If the intrinsic value is positive, the option is in-the-money. If exercising an option would

produce a loss, it is out-of-the-money.

The premium of an option consists of two elements: the intrinsic value– the prot

that would be made by exercising the option on that day – and the time value– a

measure of the chances that the option will become protable before the expiry date.

One element of the time value of an option is just the length of time that an option

has to run to expiry, since the longer that period is, the greater must be the chance

that the price of the underlying product will change affecting the protability of the

option. Further, the chances of a change occurring in a price depend not only on

the length of time but also on the volatility of the price of the underlying product.

Where the price of the underlying product normally changes frequently and by

relatively large amounts, the time value of an option will be greater for each period

to expiry than where the price of the underlying product is generally stable. It is

true that a volatile price may fall sharply as well as rise sharply, but falls in price are

relevant only to the extent that they cause the option to be at-the-money at the time

of expiry – greater falls in price will simply cause the option to be abandoned. No one

would exercise an out-of-the-money option. It follows that sharp price movements

up have a much stronger impact on the possible protability of an option and that

volatility will always be positively related to the premium.

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

Intrinsic value and time valueare related. If an option is presently deeply out-of-the-

money (it has no intrinsic value), the chances that (for any given time period and

volatility of the cash price) a change in price will make the instrument protable must

be less than if the option is only just out-of-the-money or at-the-money. Equally, if

an option is deeply in-the-money, the chances that the cash price will go on rising,

continuing to increase the protability of the option, are less than if the intrinsic

value of the option is lower.