A currency option is said to have “intrinsic value” when the strike price of the option is more favourable to execute at than the prevailing market price of the underlying contract. The greater the intrinsic value of an option, the higher its premium will be. Some important forex option terms that relate to an option’s intrinsic value are:
In currency options, intrinsic value is determined by first assessing whether a positive difference exists between the strike price of the option and the current price of the underlying foreign exchange contract that has the same delivery date as the forex option. If the strike price is out-of-the-money (worse than) or at-the-money (equal to) the rate of the underlying forex spot, forward or futures contract, then the forex option has no intrinsic value. Alternatively if the strike price is in-the-money (better than) the prevailing rate of the underlying, then the option has intrinsic value equal to the positive difference between the option’s strike price and the underlying’s price.
Furthermore, the underlying instrument involved in currency options can differ depending on what market and style of forex option you are considering. For example, American-style OTC currency options calculate their intrinsic value relative to the spot rate, since they can be exercised for a spot contract at any time the holder wishes, up to and including the expiration date. Nevertheless, in practice, American-style options are usually only exercised early when the time value of the option is close to or equal to zero. If an American-style option still has remaining time value, it is usually preferable to sell it back to the market to close out the position, rather than exercising it early and wasting the time value.
On the other hand, the intrinsic value of European-style OTC currency options is calculated relative to the forward foreign exchange rate prevailing for the delivery date of the option since they cannot be exercised before their expiration date.
In addition, both American style and European Style currency options that have a futures contract as their underlying instrument are commonly traded on exchanges. These options both calculate their intrinsic value relative to the prevailing price of the underlying futures contract that delivers on the final settlement date. Again, American-style exchange-traded forex options that have time value are usually closed out via the exchange rather than exercised early in order to recover the remaining time premium.