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JimmyL
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Posts: 32
Joined: June 10th, 2010, 11:22 pm

FX Option Questions

September 20th, 2010, 11:50 pm

Just a few miscellaneous questions...I have a basic Garman Kohlhagen framework set up in excel. First, I am a little confused as to how things are quoted. Say, for instance, I have a EUR Call/JPY Put with $Xmm in JPY notional. Which currency is "domestic," and which is "foreign?" Does it matter? How would I quote the two if I wanted to see the value of the option in % JPY notional? Also, is there an extension of the GK framework, or a different model that uses forward rates in the calculation of the value of the option? I would assume this is important for long-dated options (for instance one that expires 10Y from now). If there is such a model, is there a simple formula for calculating forward points? Checking the student forum and google have both failed me.Finally, what interest rates should I use in the calculations? If the option expires in 3 months, should I use EUR and JPY 3m libor rates, respectively?
 
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Alkmene
Posts: 301
Joined: January 18th, 2007, 10:19 pm

FX Option Questions

September 21st, 2010, 4:47 am

I like the question(s).My take and I have been struggling for a long time here; problem seems that a lot of currency traders I speak to (small sample, admitedly) are very good with their few pairs and know the conventions that apply but can hardly explain the wider rules/conventions.My take:EUR/JPY: EUR call in German Kohlhagen is expressed as JPY to buy EUR; EUR is the foreign that is bought with the domestic currency JPY. I find it easier to think of EUR being the commodity. I guess this is due to the convention of JPY units per 1 unit of EURO; just lke buying tomatoes.Quotation in %: Calculate PV of option in JPY and divide by JPY notional which is EUR/JPY per unit of notional in EUR.Extension: I think that when I last looked at it, it is the same idea as under black's model, except that the forward value of a share is replaced by the forward value of the currency (RN). So the model is already doing what you ask, I think. Be careful when looking more closely at the formulae as you need to consider which currency is the measure.Interest rates: Just like in simple option pricing: Standard is to use Libor with same tenor, but more realistic would be to somehow adjust for your cost of funding to hedge the position? Remember that Libor is some average at a point in time.Hope this helps but it would be good to get the real answers from someone else ;-)Alk
 
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daveangel
Posts: 17031
Joined: October 20th, 2003, 4:05 pm

FX Option Questions

September 21st, 2010, 6:26 am

there is a good paper by Wystrup either on mathfinance.de or somewhere on these forums
knowledge comes, wisdom lingers
 
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JimmyL
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Posts: 32
Joined: June 10th, 2010, 11:22 pm

FX Option Questions

September 21st, 2010, 5:18 pm

Dave-Is this the paper you are referring to? http://www.mathfinance.com/wystup/paper ... Alk-Thanks for the detailed responses. With regard to the correct rate to use, what if the option expires past the last libor tenor (12M). For instance, if I have a 10y option on EURJPY, should I use SGB/JGB 10Y yields initially, and then interpolate between tenors as the option moves closer to expiry?
 
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JimmyL
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Posts: 32
Joined: June 10th, 2010, 11:22 pm

FX Option Questions

September 21st, 2010, 5:19 pm

Apologies...I was thinking CHF when I wrote SGB yields. What 10Y rate/yield should I use for the EUR?
 
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Alkmene
Posts: 301
Joined: January 18th, 2007, 10:19 pm

FX Option Questions

September 21st, 2010, 10:40 pm

QuoteOriginally posted by: JimmyLDave-Is this the paper you are referring to? http://www.mathfinance.com/wystup/paper ... Alk-Thanks for the detailed responses. With regard to the correct rate to use, what if the option expires past the last libor tenor (12M). For instance, if I have a 10y option on EURJPY, should I use SGB/JGB 10Y yields initially, and then interpolate between tenors as the option moves closer to expiry?Any yield curve that you see fit for your discounting will do; interpolation is the only way albeit a poor one.Keep in mind that with 10 year FX options you have many, many problems, especially when JPY is involved:- little liquidity and hence large bid ask - what is the vol you are using?- shape of the IR curve and the dyamics are more important as rho starts to dominateetc.Alk
 
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JimmyL
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Posts: 32
Joined: June 10th, 2010, 11:22 pm

FX Option Questions

September 22nd, 2010, 12:10 am

Alk, can you send me a PM? I'm a little confused about how to do so
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