If the rate is lower than 2.0000 on December 31 (say 1.9000), meaning that the dollar is stronger and the pound is weaker, then the option is exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD ? Although FX options are more widely used today than ever before, few multinationals act as if they truly understand when and why these instruments can add to shareholder value.To the contrary, much of the time corporates seem to use FX options to paper over accounting problems, or to disguise the true cost of speculative positioning, or sometimes to solve internal control problems. about currency options affirms without elaboration their power to provide a company with upside potential while limiting the downside risk.This is confirmed by the fact that stock and currency variance premiums are poorly correlated with each other and by the evidence that the currency variance premium is not a useful predictor for local stock market returns.
In reality currency options do provide excellent vehicles for corporates' speculative positioning in the guise of hedging.
These include, among others, FCMs and affiliates of FCMs.5 FCMs and their affiliates that are not also regulated as one of the other enumerated financial entities, remain subject to the Commission's anti-fraud jurisdiction with respect to foreign currency transactions.
This paper joins the vast literature on the forward premium puzzle by relating exchange rate returns to the stock and currency variance premiums measured as the option-implied variance minus the expected or realized variance of stock and currency returns respectively.1 First, we empirically show that the foreign exchange (forex) variance risk is indeed priced in forex markets--the currency variance risk premium is a useful predictor of the exchange rate return, especially at a medium 6-month horizon.
I also explain the three sources of information about market expectations and perception of risk that can be extracted from FX option prices and review empirical methods for extracting option-implied densities of future exchange rates.
As an illustration, I conclude the Chapter by investigating time series dynamics of option-implied measures of FX risk vis-a-vis market events and US government policy actions during the period January 2007 to December 2008.