From the September 01, 2010 issue of Futures Magazine • Subscribe!

High times for currency options

The year 2010 is an exceptional time for currencies in terms of cash prices, futures and options. From Dec. 9, 2009, to May 18, 2010, the U.S. dollar index has risen from approximately 74 to 86, while the euro plunged from more than $1.50 to less than $1.25.

Debt and economic problems in euro-based countries such as Greece and Portugal undermined confidence in the European financial structure and caused those in charge of future payments and current investments to seek a safe haven in U.S. dollar assets. The resulting financial and economic shifts are advantageous for European exporters and U.S. citizens traveling abroad this summer. Meanwhile, U.S. products look more expensive — a possible cause for concern in terms of exports and trade deficits.

With currency prices having moved so decisively — up for the U.S. dollar and down for the euro — this is a good time to look at the consensus of the options market as it views currencies over the period May 2010 to March 2011. "September 2010 euro calls" (below) shows options prices predicted by the log-log parabola (LLP) option pricing regression model for 15 strike prices on May 14, 2010.

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The futures price on that date is $1.2395 per September euro, and it is noted that the predicted prices are generally accurate to one hundredths of one cent. Close correlation between market prices and prices predicted by the regression model reflects the fact that options on futures are valued to a large extent by Black-Scholes or similar theoretical price models. This is a tightly controlled market in terms of pricing and underlying variables such as volatility measures and short-term interest rates.

Breakeven prices at each strike price show the price range forecast by the options market. These prices will produce an ending profit or loss of zero for a delta-neutral trade involving September euro calls and the underlying futures contract. Prices at expiration between the upper and lower breakeven prices will result in a profit for the delta-neutral trade, while prices beyond breakeven in either direction will result in a loss.

At a strike price near the futures price on "September 2010 euro calls," the delta-neutral breakeven prices produce a price range at expiration from $1.33 to $1.17. Price ranges estimated by probability models are key inputs for determining put and call option values. As shown on "Breakeven prices" (below), the slope of the option price curve at each strike price results in a diagonal line that intersects the horizontal axis (the upper breakeven price) and also intersects the intrinsic value line directly above the lower breakeven price.

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