FOREIGN CURRENCY OPTIONS

Foreign currency options, sometimes referred to simply as currency options, are options to purchase or sell one currency at a price denominated in another currency. The price of one currency in terms of another currency is known as an exchange rate. The exercise price of a currency option thus represents an exchange rate. The currency in which the premium and exercise price are denominated is referred to as the trading currency. The currency to be purchased or sold at the exercise price is the underlying currency.

Certain of the foreign currency options discussed in this chapter, which are referred to as dollar-denominated foreign currency options, are options to purchase or sell underlying foreign currencies for U.S. dollars, and their exercise prices represent the exchange rates of the underlying foreign currencies with respect to the U.S. dollar. Other options (which are referred to as cross-rate foreign currency options or cross-rate options) that are discussed below under "Cross-Rate Foreign Currency Options" are options to purchase or sell an underlying foreign currency at an exercise price that is denominated in another foreign currency. The exercise price of a cross-rate option therefore represents an exchange rate between two foreign currencies.

While most of the foreign currency options that are traded at the date of this booklet are physical delivery options, trading has been introduced in cash-settled foreign currency options. These options are discussed below under "Cash-Settled Foreign Currency Options."

The term "foreign currency" includes not only the currencies of individual nations, but also the European Currency Unit ("ECU"). The ECU, which is composed of specified amounts of various European currencies, is the official medium of exchange of the European Economic Community's European Monetary System and is primarily intended for use in international commerce. As used in this booklet, the term "sovereign government" includes the European Economic Community.

The principal risks of holders and writers of foreign currency options are discussed in Chapter X. Readers interested in buying or writing foreign currency options should not only read this chapter but should also carefully read Chapter X, particularly the discussions under the headings "Risks of Option Holders," "Risks of Option Buyers," "Other Risks," and "Special Risks of Foreign Currency Options."

MARKET FOR FOREIGN CURRENCIES

Understanding the risks inherent in foreign currency options requires familiarity with the characteristics of the markets for the underlying currencies. Readers will find extensive literature on the subject, and this chapter can do no more than briefly summarize the most fundamental characteristics of those markets as they pertain to foreign currency options.

Foreign exchange rates can be free floating or may be subject to a variety of formal or informal governmental exchange rate control mechanisms. Exchange rates of most Western nations are permitted to fluctuate in value relative to the U.S. dollar and to each other. It must be kept in mind, however, that sovereign governments rarely voluntarily allow their currencies to float freely in response to economic forces. To the contrary, sovereign governments use a variety of techniques, such as intervention by a country's central bank or imposition of regulatory controls, to affect the exchange rates of their currencies. Thus, a special risk in trading options on foreign currencies is that governmental actions might be instituted which could interfere with freely determined currency valuation or even with movement of currencies across borders. These risks are specifically addressed under "Special Risks of Foreign Currency Options" in Chapter X.

The market in foreign currencies exists in every large financial center in the world, and primarily consists of trading by the world's international banks. In contrast to the stock market, the market for foreign currencies is decentralized, essentially free from government regulation designed to protect investors (although, as noted above, governments may take various actions that affect their own currencies and the markets on which they are traded), and extremely large. Trading is generally conducted in units equivalent to $1 million to $5 million, and the market is not structured for trading or delivery of small amounts of currency. While a "retail market" for foreign currencies is available for tourists and others engaged in smaller transactions, the prices available in that market are only generally related to prices in the "wholesale" interbank market, and it is unlikely that the prices in the retail market will be as favorable as the prices for transactions in large amounts of foreign currency.

SPECIAL CHARACTERISTICS OF FOREIGN CURRENCY OPTIONS

Foreign currency options, like other options, provide opportunities for investment and pose risks to investors as a result of fluctuations in the value of the underlying interest. Just as certain options on equity securities are priced in relation to the price of the underlying security, dollar-denominated foreign currency option prices will generally depend in significant part on the U.S. dollar value of the underlying foreign currency. Similarly, the prices of cross-rate options will tend to depend on the relative values of the underlying currency and the trading currency.

The relationship between the value of an underlying foreign currency relative to the trading currency and the prices of options on that underlying foreign currency can be summarized as follows:

1. If the value of an underlying foreign currency rises in relation to the trading currency, call premiums will normally increase and put premiums decrease.

2. If the value of an underlying foreign currency decreases in relation to the trading currency, call premiums will normally decrease and put premiums increase.

EXAMPLE: Assume a dollar-denominated call option gives its holder the right to purchase British pounds at $1.35 each. At expiration, that option will have intrinsic value if the price of the British pound is above $1.35. At the same time, it will have no intrinsic value if the price of the pound is equal to or below $1.35. The change in the price of British pounds may result from a change in the value of the U.S. dollar relative to all other currencies ("strong" dollar, "weak" dollar), from a change peculiar to the British pound ("strong" pound, "weak" pound), or from a combination of the two. In any case, the final measure of the intrinsic value of the option will be the value of the British pound relative to the U.S. dollar.

EXAMPLE: Assume a cross-rate call option gives its holder the right to purchase British pounds at 2.50 German marks ("DM") each. At expiration, that option will have intrinsic value if the price of the British pound in German marks is above DM 2.50. It will have no intrinsic value if the price is equal to or below DM 2.50 at that time. Changes in the exchange rate between German marks and British pounds may result from changes in the value of German marks relative to other currencies generally, from changes in the value of the British pound, or from a combination of the two. In any case, the intrinsic value of the option will be determined by the value of the British pound relative to the German mark, and not to the U.S. dollar or any other currency. However, as is noted in the following section, fluctuations in the value of the trading currency relative to other currencies may significantly affect investors who intend to convert their gains or losses into one of those other currencies.

Readers should note that the various expiration dates for foreign currency options are different from the expiration dates for options on other underlying interests. Readers should determine the expiration date of each foreign currency option they wish to buy or write.

SPECIAL FEATURES OF DOLLAR-DENOMINATED FOREIGN CURRENCY OPTIONS

The amount of the foreign currency underlying each foreign currency option (i.e., the unit of trading) is specified by the options market on which the option is traded.

Exercise prices for currently available dollar-denominated options on foreign currencies other than the Japanese yen are stated in U.S. cents per unit of foreign currency. Exercise prices for dollar-denominated Japanese yen options are expressed in hundredths of U.S. cents per unit. In order to determine the total exercise price per contract, it is necessary to multiply the stated exercise price by the unit of trading of the particular option.

EXAMPLE: A dollar-denominated put covering 31,250 British pounds with an exercise price of 130 would entitle the holder to sell the underlying pounds for an aggregate exercise price of $40,625 ($1.30 multiplied by 31,250).

EXAMPLE: A dollar-denominated call covering 6,250,000 Japanese yen with an exercise price of 94 would entitle the holder to buy the underlying yen for an aggregate exercise price of $58,750 ($.0094 multiplied by 6,250,000).

Because the issuer of a particular foreign currency may unilaterally issue a new currency to replace its existing currency or alter the exchange rate or exchange characteristics of its existing currency with respect to other currencies, an adjustment panel has the discretion to adiust the terms of the options on such foreign currency. (At the date of this booklet, the representative of OCC on an adjustment panel has the power to vote on adjustments to all foreign currency options whether or not the votes of the other panel members result in a tie.) Ordinarily, the terms of foreign currency options will not be adjusted to reflect a devaluation or revaluation of a currency. The monetary authorities of the European Economic Community may change the weighting and identity of the currencies comprising the ECU from time to time. Except in extraordinary circumstances, the terms of ECU options will not be adjusted to reflect such changes.

Premiums for currently available dollar-denominated options on foreign currencies other than the French franc and the Japanese yen are expressed in U.S. cents per unit of foreign currency.

EXAMPLE: If a dollar-denominated option covering 62,500 Swiss francs is purchased at a premium of .81, the cost of the option will be $506.25 (.81 cents, or $.0081,times the unit of trading of 62,500).

Premiums for currently available dollar-denominated French franc options are expressed in tenths of U.S. cents.

EXAMPLE: If a dollar-denominated option covering 250,000 French francs is purchased at a premium of .65, the cost of the option will be $162.50 (.065 cents, or $.00065, times the unit of trading of 250,000).

Premiums for currently available dollar-denominated Japanese yen options are expressed in hundredths of U.S. cents.

EXAMPLE: If a dollar-denominated option covering 6,250,000 Japanese yen is purchased at a premium of .42, the cost of the option will be $262.50 (.0042 cents, or $.000042, times the unit of trading of 6,250,000).

Settlement of exercises of physical delivery dollar denominated and cross-rate options is significantly different from settlement of exercises of other types of options. The following is a description of the settlement procedures pertaining to such options.

Exercises are settled through the facilities of OCC. For this purpose, OCC has established banking arrangements permitting it to receive and deliver each underlying foreign currency in the country of origin in satisfaction of option exercises. (Exercises and assignments of ECU options settle within a country or countries designated by OCC.) Clearing Members ordinarily deliver or receive foreign currency on the fourth business day after exercise that is also a banking day for OCC's correspondent bank in the country of origin. In the case of dollar-denominated options, cash settlement between OCC and Clearing Members (i.e., payment or receipt of the net exercise price for each day's exercises) takes place in the United States or other locations approved by OCC. In some cases, a wholly-owned subsidiary of OCC-The Intermarket Clearing Corporation-which has the same settlement procedures as OCC, may act as OCC's agent in making foreign currency settlements with Clearing Members.

For purposes of settlement between an investor and his brokerage firm, applicable rules require a holder exercising a physical delivery put option and an assigned writer of a physical delivery call option to arrange for the deposit of the requisite units of the underlying foreign currency into a designated bank account in the country issuing that currency no later than the time by which OCC requires delivery to it of foreign currency by its Clearing Members. Through this procedure, investors ordinarily rely upon their brokerage firms to make settlement with them. However, OCC has established procedures whereby Clearing Members may permit customers to make settlement directly with an OCC correspondent bank. (At the date of this booklet, such procedures are not yet available in the case of cross-rate options.) Investors should consult their brokerage firms with respect to these procedures.

At the date of this booklet, OCC expects, subject to regulatory approval, to adopt exercise settlement procedures whereby OCC's obligation to deliver or pay for underlying foreign currencies in satisfaction of option exercises may be discharged by transferring the foreign currency to be delivered, or the net exercise price for foreign currency to be received, to an OCC correspondent bank that is obligated to complete the settlement. Brokerage firms and their customers would then be relying on the correspondent bank to deliver or pay for the underlying foreign currency.

If OCC should determine that foreign governmental restrictions or taxes would prevent the orderly settlement of delivery foreign currency option exercises or would result in undue burdens on OCC or its Clearing Members, OCC has the authority to impose special exercise settlement procedures. These could range from technical changes in delivery procedures to the fixing of U.S. dollar settlement prices. OCC's authority to fix cash settlement prices for foreign currency options applies to both calls and puts. Thus, OCC could authorize exercising foreign currency put holders, as well as assigned call writers, to pay a U.S. dollar settlement price in lieu of delivering the underlying foreign currency. However, OCC also has the authority to prohibit exercises of foreign currency puts by holders who would be unable to deliver the underlying foreign currency. The potential effects of such a prohibition are discussed in paragraph 5 under "Risks of Option Holders" in Chapter X . If special exercise settlement procedures are imposed, investors may determine the nature of such procedures from their brokers.

CROSS-RATE FOREIGN CURRENCY OPTIONS

As noted at the beginning of this chapter, a cross- rate foreign currency option is an option to purchase or sell a foreign currency at an exercise price that is denominated in another foreign currency. An example of a cross-rate option is an option to purchase British pounds at an exercise price denominated in Japanese yen-that is, the trading currency would be the Japanese yen and the underlying currency would be the British pound. The exercise price would be expressed as a certain number of yen per pound. Premiums for cross-rate options are denominated in the trading currency. Thus, in the above example, premiums would be in yen.

The cross-rate options that have been approved for trading as of the date of this booklet are physical delivery European-style options. It is possible that other kinds of cross-rate options will be traded in the future.

Investors in cross-rate options should bear in mind that the magnitude and direction of any change in the value of the underlying currency in relation to the trading currency may be quite different from the magnitude and direction of any contemporaneous change in the value of either of those currencies in relation to a third currency, such as the U.S. dollar. Thus, for example, the British pound may appreciate in relation to the Japanese yen at the same time that the pound depreciates in relation to the U.S. dollar. As discussed in Chapter X under "Special Risks of Cross-Rate Options," this is of particular significance to investors who intend to convert their profits or losses on cross-rate options into U.S. dollars.

All of the previous discussion in this chapter relating to foreign currency options in general applies equally to cross-rate options except to the extent that it is specifically limited to dollar-denominated options. Certain special features of cross-rate options are discussed below.

SPECIAL FEATURES OF CROSS-RATE OPTIONS

The amount of the foreign currency underlying each cross-rate option (i.e., the unit of trading) is specified by the options market on which the option is traded.

The exercise price of a physical delivery cross-rate option is the price (denominated in the trading currency) at which the underlying currency may be purchased or sold upon exercise of the option. Exercise prices for cross-rate options are generally expressed in terms of units (or fractions of units) of the trading currency per unit of the underlying currency. Therefore, in order to determine the total exercise price per contract, it is necessary to multiply the stated exercise price by the unit of trading of the particular option.

EXAMPLE: The exercise prices of yen-denominated options covering underlying German marks are expressed in yen per mark. Therefore, a put covering 1,000,000 German marks with an exercise price of 93 Japanese yen ("JY") would entitle the holder to sell the underlying marks for an aggregate exercise price of JY93,000,000 (JY93 multiplied by 1,000,000).

The discussion in this chapter of adiustments under the caption "Special Features of Foreign Currency Options" is applicable also to cross-rate options, except that adjustments in the terms of cross-rate options might be made to reflect events affecting the trading currency as well as events affecting the underlying currency.

Premiums for currently available cross-rate options are expressed in units and decimals of the trading currency per unit of the underlying currency.

EXAMPLE: If a yen-denominated option covering 500,000 British pounds is purchased at a premium of 2.63, the cost of the option will be JYl ,315,000 (JY2.63 times the unit of trading of 500,000).

Premium settlements of cross-rate options are effected in a trading currency other than U.S. dollars. Similarly, in the event of exercise, the exercise price is paid in the trading currency. OCC has established banking arrangements permitting it to receive and pay foreign currencies in the country of origin for purposes of both premium and exercise settlement of cross-rate options between OCC and its Clearing Members. Customers ordinarily settle with their brokerage firms, although OCC may establish procedures whereby Clearing Members may permit customers to make exercise settlement directly with an OCC correspondent bank. Each customer should consult his brokerage firm to determine the procedures and time requirements for payment of foreign currencies on settlement of transactions in, and exercises of, cross-rate options.

If OCC should determine that foreign governmental restrictions or taxes or other events beyond the control of OCC would prevent the orderly settlement of exercises of, or premium payments with respect to transactions in, cross-rate options or would result in undue burdens on OCC or its Clearing Members, OCC has the authority to impose special settlement procedures. These could range from technical changes in payment procedures for the trading currency or underlying foreign currency to the fixing of U.S. dollar settlement prices payable in lieu of either currency. OCC also has the authority to prohibit exercises of cross-rate options by holders who would be unable to meet the settlement obligations resulting from the exercise. The potential effects of such a prohibition are discussed in paragraph 5 under "Risks of Option Holders" in Chapter X. If special exercise settlement procedures are imposed, investors may determine the nature of such procedures from their brokerage firms.

CASH-SETTLED FOREIGN CURRENCY OPTIONS

At the date of this booklet, cash-settled foreign currency options are also traded. These options are dollar-denominated, European-style options. Each cash-settled foreign currency option has an expiration date not more than approximately two weeks following the initiation of trading in the option. Cash-settled foreign currency options having longer expirations may be traded in the future.

The discussion above in this chapter relating to dollar-denominated foreign currency options generally applies to cash-settled foreign currency options except to the extent that such discussion specifically applies to physical delivery options.

The contract size of a cash-settled foreign currency option, like the size of other foreign currency options, is expressed in terms of the amount of the underlying currency covered by the option.

EXAMPLE: If the exercise price of a cash-settled call option on German marks is 60 (expressed as U.S. cents per mark), the exercise settlement value of the underlying currency is reported as 65, and the unit of trading is 62,500 marks, then the cash settlement amount of the option will be ($.65 minus $.60) multiplied by 62,500=$3,125.

A cash-settled foreign currency option that, based on its exercise settlement value, is in the money on the expiration date will be automatically exercised on the expiration date. In the future, cash-settled foreign currency options may provide that they will be automatically exercised only if they are in the money by a specified amount on the expiration date.

At the date of this booklet, the exercise settlement value for cash-settled foreign currency options is based upon bid and offer quotations from a sampling of participants in the interbank spot market for the underlying foreign currency at a specified time on the expiration date. The time as of which the exercise settlement value is calculated and the method of calculation is determined by the options market on which the options are traded and may be changed by it at any time. Any such change may be made applicable to options outstanding at the time of the change.

Another special feature of cash-settled foreign currency options having an expiration date of not more than two weeks following the initiation of trading is that option writers must deposit required margin with their brokerage firms within two business days of the trade date. It should be noted that this is a shorter period than the normal period required for other options transactions.

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