Don’t bet on options in currencies: Economic Times: 14th July 2010

With the success of forex futures, the logical corollary is to bring in options which have an advantage over futures in so far as that they gives the user the right but not the obligation to exercise his choice. The interest witnessed in forex futures across currencies has been palpable among bankers, traders, investors and speculators, thus making the futures rates robust and credible. The question is whether or not options would be effective in a market where the difference between the spot and futures prices is low.

Simply put, a trader who would like to say, buy dollars at a later date at a known strike price can buy an option (call option) and at the time of maturity exercise the option of not doing so in case the cash market has a better rate. Thus, a trader who buys dollars at price x in advance need not go through with the transaction if the price at the time of maturity is lower in the spot market. In return he pays a premium called the option price. The table below shows how the numbers will look when such options on the dollar are in play. Let us assume that the RBI rate is Rs 46.73, which is the price of the underlying on July 13, 2010. There are three active running contracts on the NSE, with expiry dates on 28 of July, August and September even though there are 12 listed ones. The matrix below provides the option price for these three contracts assuming that the futures price is the strike price based on two cases of volatility. The first is 6% which is the January-March average daily annualised volatility and the other is 12% for April to June. The second phase was when the currencies became extremely volatile given the Euro turmoil. In the first period, the average exchange rate was Rs 45.92 with a minimum of Rs 44.94 and maximum of Rs 46.81, while in the second quarter the average was Rs 45.67 with the two limits being Rs 44.33 and Rs 47.57.

The table gives some interesting insights about the possible scenario in this segment. The first is that the premium to be paid is higher with volatility. The second is that the cost of holding on to the privilege of exercising this right moves up with time. The third is that given that the difference between the future price and spot price is not very high numerically - ranging between 26 paise and 58 paise, the option premium appears to be high under the assumptions made here. Therefore, the incentive to pay this amount today to exercise this right at the time of maturity may be diluted given this payoff though admittedly, part of this premium will get reflected in the final strike price that is transacted.

From the point of view of a hedger, options where the premium is higher than the difference between the spot and futures (strike) price may not be too attractive unless the contracts are liquid in the ones with longer tenures, say 6 months or one year. Day traders and scalpers, who add liquidity, would not look at this avenue while speculators may move in depending on the perceived returns. However, to the extent that they do not look to hold on till maturity, there could be a constraint here. Therefore, to begin with there is reason to believe that options may have a slow start in the forex market until longer tenure contracts become more active. Also with higher volatility, while there is a priori reason for hedging or investing, the cost of transaction would be a concern. It is not surprising that globally, options on futures account for just around 2-3% of total derivative trade in currencies.