Shrinking cost of foreign exchange options

The cost of buying currency options has come down only "moderately" for clients in recent weeks and months, said options specialists interviewed by Risk’s sister publication FX Week . But in terms of the increased risk protection they currently provide for that cost, foreign exchange options are significantly better value than previously.

Premiums are lower, as a result of "broadly lower volatilities", said the head of forex options at a bank in the US, "but currency pairs are moving a lot." (Implied volatility is one of the functions that constitute an option’s price.) Another options manager at a bank in New York agreed: "Spot is very active, but as the volatilities are not going up, it’s cheaper for clients."

The relative value, however, of using currency options has shot up, as huge exchange rate volatility seen in the past three months has made the cost of an upfront premium comparatively less expensive than remaining exposed to large and unexpected currency moves.

"When currencies tend to be in a range, people don’t want to spend the money on options, said Justin Foley, head of global foreign exchange options and head of forex trading for North America at Bank One in Chicago. "But this year we have seen great moves and paying 1% or so for a premium on an option is worthwhile if the underlying position moves 6% or 7%."

This is one of the drivers in clients’ massive increase in options use so far this year. The Bank for International Settlements said in November that non-financial counterparties’ use of foreign exchange options was up 91% to $1.533 trillion for the first half year, compared with the previous six months, while anecdotal evidence from a range of banks indicates that they are seeing increased options flow from customers in excess of 50%.

"All of a sudden people who haven’t used them before are much more motivated to do so today as a result of the volatility in the markets," said Richard Giltner, global head of options at SG in Paris.

One factor making some options cheaper, he said, is the "typical margin narrowing that goes with the evolution of any product". This is especially true of ‘market veteran’ vanilla options.

With better transparency and education among clients, banks must offer more competitive prices. "When some exotic products came on to the market only banks knew how to value them," said Giltner. "Now a client can buy a bit of software that can do it for them and can follow their position," he explained.