Currency Options Extrinsic Value

EXTRINSIC OR TIME VALUE:

The premium of an option that has no intrinsic value is made up solely of extrinsic value or what is more commonly called “time value.” As its common name indicates, time value tends to increase, all other factors remaining equal, when comparing currency options with increasing times left to expiration.  Thus, an ATM option with one day left to expiration will generally have less time value than an ATM option with one year left until expiration

Nevertheless, a difference in time to expiration is not the only reason that changes an option’s extrinsic value. In fact, this component of an option’s price is greater whenever it is less certain that the option will be exercised at expiry. This explains why the time value of an at-the-money option with its strike price at the price of the underlying forex contract is going to be higher than the time value of a deep out- or in-the-money option of the same expiration date that has a greater certainty as to whether or not it will be exercised.

Basically, the extrinsic value of a currency option is a function of:

   1. The difference between the strike of the option and the current underlying rate which is the forward rate for European-style OTC forex options.

The time value of an option will be at a maximum when the strike price of an option is at-the-money or equal to the current price of the underlying forex or futures contract. When an option is struck at that price level, the degree of uncertainty surrounding whether or not the option will be exercised will be at its highest level.

As an option moves further "into-the-money," the time value of the option will fall as the probability of it being exercised increases. Similarly, if the option moves further "out-of-the-money," the time value of the option will also fall as the probability of it not being exercised increases.

2. The time until expiration of the option.

In general, the longer the time period until expiration of an option, the greater will be its potential pay-off, and therefore the more expensive it will be. While the amount of time value of an option will increase as the maturity lengthens it will do so at a decreasing rate.  Also, the time until the option’s delivery also affects the price

3. The interest rate differential between the currencies involved.

The interest rate differential between the two currencies in any particular forex option affects the option premium by affecting the relationship between the strike of the option and the current market forward rate. Any movement in the interest rate differential that shifts the underlying option further in-the-money will make the option more expensive, while any movement that shifts it further out-of-the-money will make it cheaper.

4. The expected or “implied” volatility prevailing in the currency option market for the underlying currency pair for the time frame until expiration.

The expected or implied volatility in the underlying exchange rate is perhaps the most important variable in pricing a currency option. The higher the market has priced implied volatility, the greater the market’s expectation for large exchange rate movements and hence the greater the expected maximum pay-off of an option becomes. Consequently, higher implied volatility will translate into higher premiums for both puts and calls.

Currency option market-makers often differ in their expectations of future volatility, and this creates what is essentially a traded market in the implied volatility used to price currency options. Influences on the level of implied volatility in the forex options market are:

(1)   The historical volatility of the particular currency pair (i.e. the track record of the annualized standard deviation of underlying price movements observed over some relevant time period).

(2)   The potential impact of future news and data releases on the underlying rate.

(3)   The relative demand versus supply of options of that time period.

(4)   The market’s expectations for implied volatility.

(5)   Any other factors that the market-maker feels could materially affect future movements in the currency.

5. Whether a directional bias exists in the market that favours options with strike prices that are higher or lower than the prevailing underlying rate.

In the currency options market, implied volatility is often different for significantly out-of-the-money calls versus out-of-the-money puts when a directional bias exists in the underlying market that favours the probability of one side being exercised over the other.  This phenomenon is known as the implied volatility skew. For example, if the underlying market in AUD/USD is in an established uptrend, then you can expect out-of-the-money AUD calls/USD puts to trade at a higher implied volatility level than is observed for similarly out-of-the-money AUD puts/USD calls.

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