FX Options: An Intuitive Approach

Demetri Papacostas and Francesco Tonin

In Chapters 4 and 5, we explored the theory and mathematics behind the most basic FX instruments, the environment and dynamics that drive the people involved in FX trading. We hopefully provided a sense of how all this is changing. For the next four chapters, we will go to the heart of the book, and look at FX options. By definition, this involves understanding the behaviour of instruments that are mathematically derived from spot. Therefore, we will need to use more mathematics and you will see why it was important to understand the FX spot and forward market beforehand.

In this chapter, we present the practical reasons why options are an awesome hedging and investment alternative, and then go through some basic rules and market practices. As we have seen, there are some very smart people in these markets and that the devil is in the details. The rules and how they are derived and applied often make the difference between profit and loss, a successful hedge or looking for a new job.

THE HEDGER’S PARADOX

Suppose that the treasurer of a corporation is dollar-functional¹¹ Functional currency refers to the main currency used by a business. It is the monetary unit of account