Standard Option

A Standard Option is an agreement to give the purchaser of the option the right to exchange a known quantity of one security for a known quantity of a specified currency at some time over a specified period.

When the underlying security is a currency, such a security is known as a Currency Option and it is usually used to hedge a known foreign exchange exposure.

The following is the screen display for a Standard Option that if exercised will deliver DEM 10,000 in exchange for USD 5,500 on June 30, 2001:

The following describes some attributes of Standard Options:

Strike Price and Currency:
The Strike Price and Strike Currency specify the amount that must be exchanged per unit of the underlying security, if and when the option is exercised.

For Standard Options the Strike Price Currency must be the same as the Exchange Currency.

Transaction Currency:
For most Standard Option transactions, the exchange currency is the same as the transaction currency. However, sometimes it is necessary to pay for a Standard Option in a different currency from the exchange currency. This is facilitated by specifying the required payment currency as the transaction currency.

Option Expiry Date:
This is the date by which the option must be exercised if the holder of the option wishes to exchange the specified strike price for the underlying security, as per the terms of the option contract.

Delivery Date:
This is the date on which the exchange, as specified by the contract, must occur - if the option is exercised.

Option Type:
The following two types of options can be specified:

Call Options;
Put Options.

Exercise Style:
The following two types of exercise styles can be specified:

European;
American.

Pricing Model:
The pricing model to be used during valuation can be chosen from the following models:

Black-Scholes;
Trinomial Lattice with 50 steps;
Trinomial Lattice with 100 steps;
Trinomial Lattice with 200 steps.

Intrinsic Multiplier:
Most Standard Options have an intrinsic multiplier of 1.0 which means the option holder has a right to 100% of the intrinsic value. However, in some cases the holder of the option has a right to some fraction or multiple of the intrinsic value. The intrinsic multiplier attribute allows such a feature to be captured when specifying the option.

Option Value Cap:
Most Standard Options do not have a cap on the total payout of the option. However, in some cases the issuer of the option limits the payout to a specified amount. The Option Value Cap attribute allows such a feature to be captured when specifying the option.

The Cap Limit Currency must be the same as the Exchange Currency and this amount is deemed payed as soon as the Cap Limit is reached.

Earnings:
There are no earnings associated with positions in Standard Options.

Valuation:
The value of a Standard Option is obtained by using standard finance formulas. [See Hull or Strickland and Clewlow.]

To value a Standard Option at a particular World State, it is necessary for that World State to contain:

The Price Variable Structure containing the Price Variable for the underlying security.
An Exchange Rate Structure with all the currencies involved.
The Sovereign Yield Curves for all the currencies involved;
The Volatility Skew Structure for the underlying security.

In addition to the above World Variables, it may also be necessary for that World State to contain:

The Volatility Skew Structures for all the currencies involved;
A Price Correlation Structure between all the currencies involved.

Pricing:
The price of a specified Standard Option can also be obtained by using the Valuation window and directly specifying the variables required by the pricing formula: