| Foreign Exchange Option |
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| CATEGORIES ABOUT FOREIGN EXCHANGE OPTION | |
| options | |
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In finance, a foreign exchange option (commonly shortened to just '''FX option''') is a Derivative where the owner has the right but not the obligation to exchange money denominated in one Currency into another currency at a pre-agreed Exchange Rate on a specified date.
VALUING FX OPTIONS: THE GARMAN-KOHLHAGEN MODEL As in the Black-Scholes Model for Stock Options and the Black Model for certain Interest Rate Option s, the value of a European Option on an FX rate is typically calculated by assuming that the rate follows a log-normal process. In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the risk-free interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of foreign currency per unit of domestic currency"). Then the value of a call option into the foreign currency has value : The value of a put option has value : where :S is the current spot rate :K is the strike rate :N is the cumulative normal distribution function : : :and is the volatility of the FX rate. SEE ALSO |
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