The Valuation of Currency Options

Nahum Biger and John Hull

Both Nahum Biger and John Hull are Associate Professors of Finance
in the Faculty of Administrative Studies, York University, Canada.

Introduction
Since Black and Scholes [1] published their path- single-currency bond plus a foreign currency option.
breaking paper, option pricing theory has received Thus:
considerable attention in the literature. Many authors
have shown how the basic Black-Scholes model can be P = B -I- cp
extended with its underlying assumptions being re-
laxed. The model has also found many applications in where P is the price of a bond paying either $ 1 or £p at
finance. Smith [6] provides a good overall review of time T, B is the price of a pure discount bond paying $ 1
the subject. at time T and c is the price of a European call option to
Options on a foreign currency can be defined in the purchase £1 for a dollar price of '/p at time T.
same way as options on a stock. For example, a Euro- Options would add completeness to the foreign ex-
pean call option on a foreign currency is an option to change market. For example, by combining a long
buy one unit of the currency on a predetermined date at (short) position in a currency with a put (call) option, a
a predetermined exchange rate. At the time of writing corporation or private investor could limit downside
there is no well-organized market for foreign currency risk while benefiting from favorable exchange move-
options. However, the Philadelphia, Montreal and ments. This partial hedge would be an alternative to
Vancouver stock exchanges have all submitted propos- the total hedge that can be obtained using forward
als for the creation of such a market. markets. Feiger and Jacquillat [2] point out that foreign
The prices of foreign currency options can be impor- currency options might also be attractive to a corpora-
tant in determining the values of other financial con- tion that is uncertain whether it will have a long posi-
tracts. Feiger and Jacquillat [2] consider one such con- tion in a currency (e.g., because it is bidding for a
tract, the currency option bond. (This is a bond where foreign currency denominated contract). They show
the holder can choose the currency in which coupons that the combination of a forward contract to sell the
and principal are paid according to a pre-determined currency at time T and a call option to buy it at time T
exchange rate.) Feiger and Jacquillat point out that a provides a hedge not available with forward contracts
two-currency, currency option bond is equivalent to a alone.
BIGER, HULL/VALUATION OF CURRENCY OPTIONS

Foreign currency options have received relatively equation relating c and S. The solution to the differen-
little attention in the literature. Feiger and Jacquillat tial equation is the well-known Black-Scholes option
12] develop a valuation model for two-currency, cur- pricing formula:
rency option bonds, assuming a joint stochastic proc-
ln(S/X) -H [r
ess for the exchange rate, home interest rate and for- c = S-N
eign interest rate. More recently Stulz [9] has a/T
developed a series of analytical formulas for European ln(S/X) + [r -
put and call options on the minimum or maximum of (1)
two risky assets. These can be applied to value curren-
a/T
cy options. where X is the exercise price, T is the exercise date, a^
This paper first provides a direct derivation of valu- is the instantaneous variance of the stock's return, r is
ation formulas for European put and call foreign ex- the risk-free interest rate and N is the cumulative stan-
change options using the Black-Scholes methodology. dard normal distribution function.
It then shows that the same formulas can be derived by As Black and Scholes assume that no dividends are
assuming the expectations theory of exchange rates paid on the stock during the life of the option, their
and the capital asset pricing model. The formulas are model cannot be directly applied to value an option on
illustrated with an example. The paper assumes a sto- a foreign currency. This is because an investor who
chastic process for just one variable. This produces far wishes to hold a foreign currency should always
simpler valuation formulas than those of Feiger and choose short-term risk-free foreign currency bonds in
Jacquillat |2]. The approach also has the advantage preference to holding the foreign currency in some
that it provides useful insights into the key role played non-interest-bearing account. A holding of a foreign
by the forward exchange rate in the valuation process. currency can, therefore, be considered as giving a re-
turn equal to the foreign risk-free rate and valuing an
Valuation Using Black-Scholes option on a foreign currency is, therefore, essentially
Methodology the same problem as valuing an option on a stock
In this section we value European put and call op- paying a continuous dividend. Merton [5] and Smith
tions on a foreign currency under the following as- [6] consider the latter problem on the assumption that
sumptions: the dividend yield, 8, is constant. They show that a
a) the price of one unit of foreign currency follows riskless hedge can be constructed as above, with the
a Geometric Brownian Motion; same hedge ratio, and that the valuation formula be-
b) the foreign exchange market operates continu- comes:
ously with no transaction costs or taxes; .„ ., J ln(S/X) -h [r - 8 + (CTV2)]T|
c) the risk-free interest rates in both the foreign
country and the home country are constant during the
c =

- e-^^x.N
1 ^7^
/ 1"(S/X) -h [r - 8 - (CTV2)]T1
1
life of the option.
In the Appendix we show how the assumptions in (c) 1 o/r J
can be relaxed. (2)
When valuing options on a stock. Black and Scholes
|1] make the following assumptions: (i) the stock fol- If the risk-free interest rate that can be earned on the
lows a Geometric Brownian Motion, (ii) there are no foreign currency holding, r*, is assumed to be con-
penalties for short sales, (iii) transaction costs and tax- stant, the "dividend yield" from an investment in the
es are zero, (iv) the market operates continuously, (v) foreign currency (when measured in terms of the home
currency) is constant and equal to r*. Hence, if we
the risk-free interest rate is constant, and (vi) the stock
redefine variables as follows:
pays no dividend. They show that it is possible to
create a riskless hedge using only the stock and Euro- S: spot price of one unit of the foreign currency;
pean call options written on the stock. The holdings in CT^: instantaneous variance of the return on a for-
the hedge must be continuously adjusted so that the eign currency holding;
ratio of the number of stock held to call options sold is X, T: exercise price and date of a European call op-
always dddS where S is the stock price and c is the call tion to purchase one unit of thp foreign curren-
price. In equilibrium the return on the hedge must be cy;
the risk-free interest rate and this leads to a differential r: risk-free rate of interest in the home country;
36 FINANCIAL MANAGEMENT/SPRING 1983

then, under the assumptions given at the beginning of It is clear from (5) and (7) that the forward rate plays
this section. Equation (2) provides a valuation formula a central role in the valuation of foreign currency op-
for a European call option written on the foreign cur- tions, c and p depend on F, X,CT,T and r rather than on
rency when 8 = r*: S, X, a, T and r (which are the parameters involved in
valuing stock options). This suggests an insightful ex-
ln(S/X) -^ [r - r* tension of the Black-Scholes approach where an inves-
7 tor forms a riskless hedge by combining forward con-
tracts with a short position in call options. The details
ln(S/X) -I- [r - r* - (CTV2)]T1
are presented in the Appendix. Formulas similar to (5)
CT/T and (7) are produced without the assumption of the
(3) foreign risk-free rate being constant.

Define F as the forward rate on the foreign currency Alternative Approach

for a contract with delivery date T. Interest rate parity It is interesting that the formulas in (5) and (7) can
theory implies: also he derived under the following assumptions:
a) the covariance between the foreign exchange
ln(F/S) = (r - r*)T (4) rate and the returns from an international market
and substituting (4) into (3) the valuation formula re- portfolio is zero;'
duces to: h) the spot rate follows a Geometric Brownian Mo-
tion with instantaneous standard deviation, a;
ln(F/X) 1 c) the international Sharpe-Lintner capital asset
pricing model holds.^
a/T Assumption (a) implies that the covariance of the
returns from an option on the foreign currency and the
ln(F/X) - ((
returns from the international market portfolio is zero.
a/T From assumption (c) it follows that options on the
foreign currency should be valued at their expected
To value a European put option with exercise price
terminal value, discounted at the risk-free rate, i.e..
X and exercise date T, an argument similar to that in
Merton [5] relating put and call prices for a stock can X) f(S, I So) dS,
be used. The terminal value of the put option is the c =
same as the terminal value of a portfolio consisting of: and
i) a call option with exercise price X and exercise p = So)
date T; O
ii) (X — F)e"'^ of risk-free bonds; where S^. is the price of the foreign currency at time T,
iii) a forward contract with delivery date T to sell 1 So is the price of the foreign currency at time O and f is
unit of the foreign currency for price F. the probability distribution of Sj conditional on So.
As is well-known, assumption (b) implies that
Since the value of the forward contract is zero, it fol- lnCS^^/So) is normally distributed with standard devi-
lows that the value of the put option, p, is given by: ation a / T . The lognormality property of Geometric
Brownian Motion has been found appealing in the case
p = c -F (X - F)e-'\ (6) of stocks by many researchers. In the case of a foreign
currency it is worth noting that it has an added appeal.
Since 1 - N(q) = N( - q) we obtain:
If the price of the foreign currency expressed in terms
ln(X/F) -I of the home currency ( = S^) is lognormal then the
p =
CT/T } (7)
'This is at best only approximately true. Recent theoretical and empiri-
cal work suggests that the covariance may be non-zero. See for example
Hansen and Hodrick [4] and Stuiz 18].
ln(X/F) -
^See, for example, Grauer et al. [3] for a discussion of the international
a/T capital asset pricing model.
BIGER, HULL/VALUATION OF CURRENCY OPTIONS 27

price of the home currency expressed in terms of the could ensure that it would obtain a minimum of
foreign currency (= l/S^.) is also lognormal. $0.79M; at a cost of $12,300 it could ensure that it
Using integrals of the lognormal distribution that are would obtain a minimum of $0.8lM. All of these
derived in an appendix to Sprenkle [7] and reproduced strategies would be alternatives to using the forward
by Smith |6] it follows that: markets where, at virtually no cost, the company could
ensure that it would obtain exactly $0.80M.
ln(S/X) + [p Call options could be used in a similar way by a
c =
a/T company due to pay out a certain sum of money de-
(8) nominated in a foreign currency at a certain time in the
ln(S/X) + [p - future.
a/T Summary
where p is the expected average growth in the price of The results in this paper provide an elegant applica-
the foreign currency. tion of the Black-Scholes methodology. It is interest-
From assumptions (a) and (c) it follows that the ing that the forward rate plays a central role in the
forward rate, F, is an unbiased predictor of the spot valuation formulas. The generality of the analysis in
rate at time T. Hence, the Appendix suggests that the forward rate is central
to the valuation of European put and call options on
pT = In F/S (9) any income-producing security.
When (9) is substituted into (8) we obtain precisely the References
same formula for c as (5). A similar analysis leads to 1. F. Black and M. Scholes, "The Pricing of Options and
the same formula for p as (7). Corporate Liabilities," Journal of Political Economy
(1973), pp. 637-659.
Example 2. G. Feiger and B. Jacquillat, "Currency Option Bonds,
To illustrate these results we consider a U.S. com- Puts, and Calls on Spot Exchange and the Hedging of
pany that is due to receive Can. $1M in 3 months' Contingent Foreign Earnings," Journal of Finance (1979),
time. We assume that the 3-month forward rate for the pp. 1129-1139.
Canadian dollar is $0.80, that the 3-month risk-free 3. F. L. Grauer, R. H. Litzenberger and R. E. Stehle, "Shar-
ing Rules and Equilibrium in an International Capital Mar-
interest rate is 2.5%, and that the standard deviation of
ket Under Uncertainty," Journal of Financial Economics
lnCS^/So) is 0.02 where, when SQ is the spot rate at a (1976), pp. 233-256.
certain time, S^. is the spot rate 3 months later. 4. L. Hansen and R. Hodrick, "Forward Exchange Rates as
The price, p, of a put option to sell Can. $ 1 for $0.80 Optimal Predictors of Future Spot Rates: An Econometric
in 3 months is given by substituting X = 0.80, F = Analysis," Journal of Political Economy (1980), pp. 829-
1 853.
0.80, -and ujT = 0.02 in equation (7): 5. R. C. Merton, "Theory of Rational Option Pricing," Bell
1.025 Journal of Economics and Management Science (1973),
pp. 141-183.
1 1
P = X 0.80 X N([Link]) - 6. C. W. Smith Jr., "Option Pricing: A Review," Journalof
1.025 1.025 Financial Economics (1976), pp. 3-51.
X 0.80 X N(-[Link]) = 0.0062 7. C. M. Sprenkle, "Warrant Prices as Indicators of Expecta-
tions and Preferences," in P. Cootrev, ed.. The Random
Similarly, the price of a put option to sell Can. $1 for Character of Stock Market Prices, Cambridge, Mass, MIT
$0.79 in 3 months is $0.0025 and the price of a put Press (1964), pp. 412^74.
option to sell Can. $1 for $0.81 in 3 months is 8. R. M. Stulz, "A Model of International Asset Pricing,"
Journal of Financial Economics (1981), pp. 383-406.
$0.0123.
9. R. M. Stulz, "Options on the Minimum or the Maximum
Thus, given an efficiently-functioning market for of Two Risky Assets: Analysis and Applications," yoMr/i«/
currency options, the company could choose between of Financial Economics (\9%2), pp. 161-185.
a number of different hedging strategies. At a cost of 10. S. [Link], "A Note on the Pricing of Foreign Curren-
$6,200 it could ensure that it would obtain a minimum cy Options," Working Paper, Department of Economics,
of $0.80M for the Can. $1M; at a cost of $2,500 it University of Toronto, (March 1983).
28 FINANCIAL AAANAGEMENT/SPRING 1983

Appendix where cjp is the instantaneous standard deviation of F.

An investor can form a riskless hedge by combining (This is the same as the standard deviation of F, under
a long position in forward contracts with a short posi- Geometric Brownian Motion.)
tion in call options. At any given time, t, he must Since F, = at t = 0, (A-1) becomes:
adjust his portfolio so that the ratio of forward con-
tracts held to call options sold is ^d^F^ where F, = ln(F/X)
Pg-r(T - 0^ gj^jj p jg {j^g forward rate at time t for a c =
contract with delivery date T. (This hedge ratio is (A-2)
explained by the fact that when F increases by 8F the
value of a forward contract increases by 8Fe''<^ " ".) If ln(F/X) -
it is assumed that
a) F follows a Geometric Brownian Motion;
b) the forward exchange market operates continu-
ously with no transaction costs and no taxes; Thus, if it can be assumed that the forward rate follows
c) the home risk-free rate, r, is constant, a Geometric Brownian Motion it is not necessary to
an analysis analogous to that of Black and Scholes [1] assume a constant foreign risk-free rate. Equation (A-
provides a differential equation relating c and F, the 2) is the same valuation formula as (5) withCTbeing
solution of which is replaced by Cp. When we make the additional assump-
tion that the foreign risk-free interest rate, r*, is con-
ln(F,/X) + [r stant, F follows a Geometric Brownian Motion if and
c = F,-N
} only if S does and Cp = a. The result in (A-2) then
becomes equivalent to the one in (5).
(A-1) In a recent working paper, Turnbull [10] has ex-
tended the results in this paper still further to deal with
ln(F,/X) + [r -
situations in which interest rates in both the domestic
and foreign country are stochastic.