The value of one country’s currency relative to another’s is constantly changing and is known as the exchange rate. Large commercial banks exchange currencies for their own accounts and for the accounts of large banks and commercial customers in the Interbank market. The Interbank market is a large unregulated marketplace where currencies are traded in spot and forward transactions. A spot transaction is an exchange of currencies that will settle in two business days. A forward transaction is an exchange of currencies that will settle on an agreed upon date that is more than two business days in the future. Most forward transactions will settle in either 1, 3, 6, 9 or 12 months. The exchange rate under which the currencies will be exchanged for both spot and forward transactions is agreed upon on the trade date.

Spot Rates

The term spot rate is used by traders and investors to reference or quote the exchange rate between currencies. The spot rate can be quoted in U.S. or European terms. A U.S. quote states the number of U.S. dollars needed to purchase a unit of the relevant foreign currency. If, for example, the British pound is quoted in U.S. terms at 1.75 it takes $1.75 to purchase one British pound. The corresponding European quote would be the reciprocal of the U.S. quote. To find the European terms use the following formula: 1 / U.S. terms. In this case 1/ 1.75 = .571 British pounds are required to purchase one U.S. dollar. Accordingly, the U.S. quote is the reciprocal of the European quote. If a spot rate is quoted in European terms to find the corresponding U.S. quote use the following formula 1 / European terms.

Foreign Currency Options

The value of one currency relative to another constantly fluctuates. The U.S. dollar is the benchmark against which the value of all other currencies is measured. During any given point, one U.S. dollar may buy more or less of another country’s currency. Businesses engaged in international trade can hedge their currency risks through the use of foreign currency options. Foreign currency options may also be used by investors to speculate on the direction of a currency’s value relative to the U.S. dollar.

Foreign Currency Option Basics

As the value of another country’s currency rises, the value of the U.S. dollar falls. As a result, it would now take more U.S. dollars to purchase one unit of that foreign currency. Conversely, if the value of the foreign currency falls, the value of the U.S. dollar will rise and it would now take fewer U.S. dollars to purchase one unit of the foreign currency. The value of foreign currencies is inversely related to each other. U.S. investors can only trade options on the foreign currency. No options trade domestically on the U.S. dollar. Foreign currency options trade on the Philadelphia Stock Exchange or “PHLX” now part of NASDAQ. The exchange sets the strike prices, expiration cycle and the amount of the foreign currency covered under each contract. Foreign currency options settle in the delivery of the foreign currency. To calculate the total premium for a foreign currency option, use the following table:

 

Currency

Australian

Dollar

British

Pound

Canadian

Dollar

 

Euro

Japanese

Yen

Swiss

Franc

Contract

Size

 

10,000

 

10,000

 

10,000

 

10,000

 

1,000,000

 

10,000

 

Premium

Quote

 

Cents per unit

 

Cents per unit

 

Cents per unit

 

Cents per unit

Hundredth

of Cents per unit

 

Cents per unit

Quote

$.01

$.01

$.01

$.01

$.0001

$.01

 

To calculate the total premium, multiply the quoted premium by .01. If the option is for the Japanese yen, multiply the quoted premium by .0001. Once you have determined the quoted premium, multiply it by the number of foreign currency units covered by the contract.

MARKET VOLATILITY OPTIONS (VIX)

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