Question

What are the six drivers of foreign currency option premiums, which two are the most important? Why are the others more or less irrelevant right now?

Answer 1

There are seven drivers of foreign currency option premium i.e. Stock Price, Strike Price, type of option, tine to expiration, Interest rates, Dividend and future volatility of seven factors, only one is not known with any certainty i.e. volatility.

1. Stock Price- If a call option allows you to buy a stock at a specified price in the future than the higher that price goes, the more the option will be worth.

- A call option allows you to buy the Option for $100 while it is trading at $80 or

- A call option will enable you to purchase the Option for $100 while it is trading at $120.

So,no one is going to buy option from $100 when they can buy on the open market for $80, so our option in first choice will have a low value.

2. Strike Price- Strike price follows along the same lines as stock price. When we classify strikes, we do it as in- the-money, at-the - money or out- of- the- money. When a call option is in-the- money, it means stock price is higher than the strike price. When a call is out-of-the- money, the stock price is less than the strike price.

A option call has a strike of 50 while it is trading at $60, this option is in the money.

On the other side, when a put Option is in-the-money when the stock price is less than the strike price. A put Option is out - of- the-money when the stock price is higher than the strike price.

When a put Option has a strike of 20 while it is trading in market at $40, this option is out-of-the-money.

3. Type of Option- An option is either a put or a call, and the value of the option will change accordingly.

- A call option gives the holder the right to buy the underlying at a specified price within a specific time period.

- A put option gives the holder the right to sell the underlying at a specified price within a specific time period.

If you are long a call or short a put your option value increases as the market moves higher. If you are long a put or short a call your option value increases as the market moves lower.

4. Time to expiration-Options have a limited lifespan thus their value is affected by the passing of time. As the time to expiration increases the value of the option increases. As the time to expiration gets closer the value of the option begins to decrease. The value begins to rapidly decrease within the last thirty days of option' s life. The more time an option has till expiration, the more time the Option has to move around.

5. Interest rates- Interest rates have a minimal effect on an option's value. When Interest rates rise a call option's value will also rise, and a put Option's value will fall.

6. Dividends- Options do not receive dividends, so their value fluctuates when dividends are released. When a company releases dividend , they have an ex- dividend date. If you own the stock on that date , you will be awarded the dividend. Also on this date, the value of the stock will decrease by the amount of the dividend. As dividends increase a put Option's value also increases and a calls' value decreases.

Out of these 6, stock price and strike price are most important