Extrinsic Value

The premium of an option that has no intrinsic value is made up solely of time value. Time value reflects the uncertainty of an option being exercised at expiry.

The time value of an option is a function of:

  1. The relationship between the strike of the option and the current market forward rate
  2. The time period of the option
  3. The interest rate differential
  4. The expected volatility in the underlying currency-pair.

Relationship between strike and current market forward rate

The time value of an option will be at a maximum when the strike price of an option is equal to the current forward rate. At that point, 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.

Time Period

In general, the longer the period of an option, the greater 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.

Interest Rate Differentials

The interest rate differential between the two currencies in any particular 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; any movement that shifts it further out-of-the-money will make it cheaper.Volatility

The expected volatility in the underlying exchange rate is the most important variable in pricing a currency option. The higher the volatility the greater the potential for large exchange rate movements and hence the greater the potential pay-off of an option. Consequently, higher volatility will translate into higher premiums for both puts and calls.

Option traders often differ in their expectations of future volatility. Influencing a traders expectations will be the historical volatility of the particular currency pair (i.e. its recent track record), the potential impact of future news and data releases on the currency, the relative demand for options, other traders expectations and any other factors that the trader feels could materially affect future movements in the currency.

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