Do Exotic options offer any specific advantages in Forex trading?

TABLE OF CONTENTS

Title:

Introduction:

Literature Review:

Dollar Fundamentals:
1) Foreign holdings of dollar assets:
2) Interest Rates:
3) The carry cost, yield and bond spreads:

Dollar Technicals:

Advantages of trading the forex market over equities and commodities trading:
1) Instant and Accurate Execution:
2) Commission free trading:
3) 24 hour liquid market:
4) Powerful Leverage with limited risk:

Options:
Types of Barrier Exotic Options Available:
Advantages of User Defined (Exotic) Options:
Option Premiums, Pricing, Volatility and Trading

Research Objective:

Methodology:
Research Design:

Results:
Analysis
Table 2: Most Profitable Trade Analysis

Discussion:

Conclusion and Recommendations:

References:

Acknowledgements:

Appendix

Title:

Do user defined exotic options offer any specific advantages in forex trading?

Introduction:

The Foreign Exchange market, commonly referred to, as the "Forex" or "FX" market, is the largest financial market in the world, averaging a daily average turnover rate of approximately $1.9 trillion. In comparison, the worldwide daily market for equities is about $50 billion, and the value of global futures contracts traded at exchanges around the world amounts to about $30 billion (fxcm.com). Hong Kong a leading forex centre averages a daily volume of 91 В (Pawlyna, 1996) that in itself exceeds combined futures and equity volumes.

Currencies are a part and parcel of every day life. Currency prices can influence a country’s trade balance by influencing the levels of imports and exports. Additionally the value of a currency can impact business travel, communication and global transactions. Currencies play a major role in international government relations. In the past year the Japanese government aggressively intervened to sell its currency and buy the dollar when local exports were under threat from a rapidly rising yen. Additionally some countries like Australia, Canada and New Zealand produce sizeable quantities of raw commodities, which constitute a major portion of their gross domestic product. The rapidly increasing demand for these commodities has resulted in increases of the respective currencies versus the dollar (Mooney, 2004).

Given the global nature of the Forex market, news and events occurring in any corner of the world can affect Forex price movements. It is almost impossible for even professional traders to keep abreast of it all, and even if one does market shocks such as a Mad Cow case, a SARS outbreak, and rising or falling threats of terrorism can occur out of the blue, making it impossible to anticipate and trade on such news. The only solution is to achieve a broader understanding of which fundamentals matter most at any given time and targeting one’s efforts there (Cofnas, 2004).

Traditionally, Forex market participants have always been for the bigger players. These include major international commercial and investment banks, large multinational corporations, global money managers, currency dealers, and international money brokers. More recently, online brokers offering FX trading platforms, have given smaller financial institutions, futures traders, and private investors access to the same liquidity and tight spreads once available only to the larger players by offering a gateway to the primary, Interbank market. This has caused forex and forex derivative trading volumes to increase significantly in the last 3 years. A 112% increase in forex derivatives was observed between 2001 and 2004 (Neville, 2005). Options constitute a large portion of the derivates traded on currencies. These are further classified into plain vanilla options, which have a fixed strike price and a fixed expiry date that traders don’t have any control over and exotic options, which are typically user defined, where the trader has the ability to pick his time of expiry and strike price. Unlike their regular counterparts exotic options are not actively traded and their prices and implied volatilities are not often quoted by brokers and financial publications. These options have risen in popularity for a number of reasons. First of all they may meet a genuine hedging need in the market place. The other reason for their popularity is that corporate treasurers frequently use these options for tax, accounting, legal or regulatory reasons (Hull, 2003).

Hull, 2003 has described several types of exotic options in detail. Included among these are forward start options, compound options, chooser options, binary options, look back options, Asian options and barrier options. This study will specifically look at the barrier family of exotic options on selected currencies. It will compare the returns of the above option class on the chosen currencies with similar European options. It will specifically be directed at determining whether this group of exotic derivatives offer any particular advantages in trading the Forex market over their European Counterparts.

Literature Review:

As stated earlier the Forex market is the largest financial market in the world generating almost 2 billion in daily trading volume, dwarfing the equity and commodity markets in comparison. The primary drivers for Forex price movement include macro­economic announcements such as payroll figures, consumer confidence data, Inflation data, and federal reserve interest rate announcements (Han & Ozocak, 2002), speculator sentiment (Wang, 2004) and the prevailing interest rate differential between the respective currencies, often referred to as the carry cost (Lavoie, 2002/2003). The other factor behind the popularity of currency trading is that currencies prices tend to respond well to technical analysis methods. Forex markets are known to create easily identifiable chart patterns, and respond better at key Fibonacci levels and pivot points than other markets (Mooney, 2004; Cofnas, 2003B). Hence it is important to understand fundamental and technical factors that influence the value of the dollar.

Dollar Fundamentals:

The attractiveness of the Forex market is exemplified by the fact that currencies tend to trend well over long periods of time. There are many reasons why currencies don’t change their underlying trend frequently in short intervals of time and often move in one direction. A major reason for this is currency prices are determined by government monetary and fiscal policies discussed above that don’t change from one day to the next. Only when underlying fundamentals deteriorate tends change and new ones are established. A good example of this is the European single currency, the euro. When it was first introduced in December 1998, there was not much appetite for it, as there was a tremendous ongoing boom in the US equity markets and capital was rapidly pouring into the United States. The trend reversed following the burst of the US equity bubble and the Euro started an impressive accent against the dollar (Mooney, 2004). However with growth still anemic in the Euro zone and the fed raising interest rates to curb the rapidly growing US economy, the two year uptrend in the Euro could be subject to reversal yet again. These fundamental factors are explored in detail below:

1) Foreign holdings of dollar assets:

At the heart of fundamental analysis is the economics of currency price movement. That is understanding why the U.S. dollar is going up or down. Supply and demand drivers for the dollar provide critical insights into this. The worlds demand for dollars will rise if dollar-based assets are in vogue and are increasing in demand. Similarly, the world demand for euros or yen will similarly increase if euro or yen-based assets are in favor. From 1998-2000 the rapidly rising equity market in the US meant dollar assets were in favor, this enabled a rapid rise in the value of the dollar versus the Euro. The bursting of the equity bubble in the US in 2000 changed this and the Euro started to appreciate against the dollar. The trend has lasted through 2004, following more evidence that the world economy was growing. And growth was not just in the United States, it was also in Asia and parts of Europe. Growth often attracts capital, In 2005 the rapidly growing US economy has clearly shifted this flow of capital in it’s favor making it by far the predominant currency and its underlying fundamentals cannot be ignored (Cofnas, 2004).

The United States generates about $11 trillion in gross domestic product (GDP). Production of that scale means that the U.S. is always a net importer of goods. Because of this, U.S. dollars often wind up with foreign holders. Current Foreign bank holding of U.S. dollars totals a record of more than $1 trillion dollars. Understanding what happens to these U.S. dollars held abroad provides valuable information that can be used to predict the appreciation or depreciation of the dollar versus the world’s major currencies. The dollars invested abroad are often cycled back into dollar-based assets. These then get reinvested into U.S. debt such as U.S. Treasury bonds. The reinvestment of U.S. dollars back into U.S. debt securities and this provides a cushion of support for the US dollar. The dollar would clearly have a much lower value without such foreign holdings of U.S. debt and would decline if such holders of debt would sell their dollar assets in the future. Thus fundamentals tell the Forex trader that the world has a $1 trillion bet on the dollar not falling in value too far or too fast. By tracking the Federal Reserve data on custodial holdings of U.S. dollars, one can see signs of dollar strength or weakness. This $1 trillion dollar debt poses an interesting conundrum. If the foreign demand for U.S. debt suddenly or sharply declines, this could cause havoc in the U.S. bond market by pushing up US interest rates. The increase in interest rates could have a ripple effect on U.S. equity and bond markets. Any decline In U.S. equities or bonds would indicate a global vote of no­confidence in the U.S. economy (Cofnas, 2004). However, at least so far in 2005, the dollar is receiving more and more support from overseas holders of U.S. debt. Until other economies offer real alternative prospects of returns on holdings, the dollar will continue to remain the top reserve currency in the world.

2) Interest Rates:

An on-going fundamental factor is the U.S. Federal Reserve’s interest rate policy. The Federal Reserve open market committee (FOMC) has raised rates 12 times since June 2004 and currently stands at currently at 4%. This has been done in an effort to bring the federal funds rate to a more neutral level, that is, a level where rates are neither triggering inflation nor slowing growth, rates. Policy has been generally formulated in a forward-looking manner with price stability and economic stability often serving as implicit or explicit guides. That means The Federal Reserve generally increases interest rates when inflationary pressures appear to be rising and lowers interest rates when inflationary pressures are abating and recession appears to be more of a threat (Orphanides, 2003). With GDP growth continuing at very high annualized levels, the tightening cycle embarked by the fed could be here to stay. This could signal the beginning of the end of dollar weakness observed in the last two years. The sequence of events leading to interest rates rising is almost as important as a rise in rates itself. With U.S. rates being raised and this is not followed by the European Central Bank raising rates, the prospects for a continued dollar rally are greater due to the differential between U.S. interest rates and Europe. Thus If U.S. rates are not raised in any given Federal Reserve meeting, the expectation that rates may be raised at the next meeting will dominate trading. The rapidly growing us economy has resulted in higher rates and a differential of 2% over Euro zone rates that has facilitated the dollar rally.

3) The carry cost, yield and bond spreads:

A look at the recent past can tell us how interest rates have played a role in dictating currency movement. After the burst of the tech bubble in 2000, traders were intensely risk averse and went from seeking the highest possible returns to focusing on capital preservation. But since the U.S. was offering record low interest rates well below 2%, many hedge funds and institutions with access to the international markets went abroad in search of higher yields (Lien, 2005). Countries like Australia, New Zealand and Canada with the similar risk factors as the U.S., offered interest rates well in excess of 5%. This attracted large amounts of capital into these countries, which in turn found their way into assets denominated in the respective currencies namely the Australian, Kiwi and Canadian Dollar.

These large and favourable interest rate differentials have led to the emergence of what is called the carry trade, which is simply an interest rate arbitrage strategy that takes advantage of the differences in interest-rates between two major economies, while aiming to benefit from the general direction or the underlying trend of the currency pair. This trade essentially involves buying one currency and funding it with another. The most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of the very low cost of borrowing in these countries, where interest rates remain below 1%. The popularity of the carry trade is one of the main reasons for the recently observed strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar versus the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USD/CAD). While transaction costs, make it almost impossible for individual investors to send money back and forth between bank accounts around the world, investment banks, hedge funds, institutional investors and large commodity trading advisors generally have the ability to tap into these global markets at relatively low spreads. As a result, they are able to move money back and forth in search of the highest yields with the lowest default risk. This in turn influences the underlying currency, as the movement in exchange rates is based upon changes in underlying money flows. Individual investors can take advantage of this potential shift in flows by monitoring yield spreads and the anticipation for potential changes in interest rates that are built in those yield spreads (Lien, 2005).

When the underlying yield spreads began to rise in the summer of 2000, commodity currencies such as the Australian, Kiwi and Canadian dollar responded with a similar rise a few months later. The 2 -3 % yield spread advantages of these currencies over the U.S. dollar, resulted in huge gains of well over 30% in the following three years. Traders who embraced this trade not only enjoyed the sizable capital appreciation that was available, but also pocketed the annualized interest rate differential. Since June 2004, rates in the U.S. have gone up 12 times and the interest rate differential between the dollar and these high yielding currencies have narrowed significantly resulting in a sharp fall in the values of these currencies over the past few months.

The spreads of both the five and ten year bond yields can also be used to predict currency movement. It is often observed that when the yield spread widens in favour of a certain currency that currency will appreciate against other currencies. However, currency movements are impacted not only by actual interest rate changes but also by expectations of changes in economic assessment by central bank and corresponding signals to raise or lower interest rates. A clear example of this occurred in 1998 when shifts in the economic assessment of the Federal Reserve led to sharp movements in the U.S. dollar. In 1998, when the Fed shifted from an outlook of economic tightening, to a neutral outlook, the dollar started its decline even before the Fed moved on rates. The same kind of movement of the dollar was observed when the Fed moved from a neutral to a tightening bias in late 1999, and again when it entered an easing monetary cycle in 2001. Once the Fed just began considering lowering rates, the dollar reacted with a sharp sell-off. If this relationship held in the future, given the current tightening cycle adopted by the fed since the middle of 2004, traders can expect the dollar to continue its recent rally. However trends and fundamentals play out over time and cannot be predicted over the very short term (Lien, 2005).

Dollar Technicals:

An attractive aspect of currency trading is that currencies prices tend to respond well to technical analysis methods. Forex markets are known to create easily identifiable chart patterns, and respond better at key Fibonacci levels and pivot points than other markets. While currency markets are driven by long-term market forces, the individual trader must develop good risk management strategies while trading these markets. That means developing good entry and exit strategies are critical for success in trading these markets. A good way to go about this is to keep on top of Fibonacci retracement levels within larger price waves. These points often indicate when retracements end and trends resume. These help the trader choose not only his entry and exit points but also stop levels whereby he can minimize his losses if the trade moves against him. Failure of which results often in exposure to excessive risk or trades being quickly stopped out. Fibonacci fans provide clear price levels where positions can be entered and exited when a clear underlying trend develops. Thus it helps eliminate the temptation to focus on trades of very short time-frames of 15 minutes to half an hour while ignoring the broad underlying trend and detecting turning points within the trend, helping in better noise filtration (Cofnas, 2003B).

There are three main reasons for participating in the Forex market:

One is to facilitate an actual currency exchange, whereby an international corporation, for instance, may convert profits earned in foreign currencies back into its domestic currency (Adam-Muller, 2000). Secondly Hedging is another common commercial use of the Forex market where finance departments of large multinational corporations routinely use the FX market in order to hedge against unwanted exposure to any future price movements in the currency market (Adam-Muller, 2000), commodity indices traditionally used to hedge economic risk have fallen out of vogue (Haigh and Holt, 2002). And finally, speculation for profit represents the most popular use of the Forex market; estimates suggest that more than 95% of all Forex trading represents speculative activity (Carey, 2004). We will look at this aspect of the Forex market exclusively in this report.

There are several reasons to explore the Forex market for speculation. Some of the specific advantages over other markets such as the equity and commodity markets are discussed below:

Advantages of trading theforex market over equities and commodities trading:

1) Instant and Accurate Execution:

Given the forex market is an all-electronic market place, executing and filling orders usually takes only 1-2 seconds. Execution is directly off real-time, streaming quotes, once the currently displayed bid or offer is clicked, the trade is instantaneously confirmed at that price. This is seldom the case with the equity or commodity markets. Usually, market, stop, and limit orders are executed without any slippage or partial fills, unlike the equity and commodity market where slippages and partial fills are routine. Only, under extremely volatile conditions, is trading efficiency disrupted.

2) Commission free trading:

There are no commissions involved whatsoever. Commissions are not charged to trade or maintain an account, regardless of account balance or trading volume contributed. The only cost of trading involved is the bid-offer spread, which is about 4 basis pts. Most equity/commodity brokerage houses will charge a commission for each trade plus a minimum maintenance fee. The highly efficient, over-the-counter, all- electronic structure of the currency market makes this possible.

3) 24 hour liquid market:

With a daily trading volume of over $1.9 trillion, the spot FX market far exceeds the $50 billion daily market for equities and the $30 billion futures market. There’s an active, liquid forex market continuously, 24 hours per day, from Sunday evening through Friday afternoon. This means tight bid/ask spreads, 24 hours per day. Dangerous trading gaps don’t exist, as is the common norm with the equities and commodities markets between 4 pm and 8 am in the workweek. A lot can happen overnight in the 8 hr gap, during which these market remains closed. Getting in and out of positions is not as easy as in the forex market where orders are executed instantly, 24 hours, without slippage or partial fills.

4) Powerful Leverage with limited risk:

The forex market allows a leverage of as high as 200: 1 (Carey, 2004). A margin deposit of just $500 allows you to control a $100,000 position in the forex market. That’s a 0.5% margin. Trading leverage in the equity and commodity futures market, are much lower running anywhere between 10-1 and 20-1. But at the same time, the risk from trading Forex on-line is strictly limited. The FX trading platform will automatically close the necessary positions to cover any margin calls on a standard FX account, if the equity falls below the level required to hold the positions. There is never a risk of a margin call and accounts will not have a debit balance when trading FX.

Options:

Options on currencies have the same fundamental characteristics as stock options except that the underlying asset is a futures contract involving the particular currency, rather than shares of stock. An option on a futures contract gives the buyer or owner (also called the holder) the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) the underlying futures contract, at an agreed upon price (known as the strike price), on or before the option expiration date (cboe.com). If the option strike price is greater than the underlying assets trade price in the case of a call option, it would be deemed to be in the money; otherwise it would be considered out of the money. The reverse would be true for a put option.

Options on futures are traded at the same exchanges that trade the underlying futures contracts and are standardized with respect to the quantity of the underlying futures contracts (almost always one futures contract), expiration date, and strike price (the price at which the underlying futures contract may be bought or sold). An option has a limited life and its value declines as time passes. It may even expire worthless, so the holder may have to exercise it in order to recover some value before expiration. The holder could alternatively choose to sell the option in the marketplace prior to expiration (cboe.com).

User defined (Exotic) options take this market timing aspect out of trading by eliminating the need for timing the entry and exit of positions. They also help minimizing the tendency to take profits too early and also the improper use of stop loss orders (refcofx.com). Exotic options are very popular and have been widely used in several other industry segments, such as the electricity supply market (Kamat, 2002) and the agricultural sector (Hart, 2001). Hull, 2003 has described a number of exotic options in detail. Included among these are forward start options, compound options, chooser options, binary options, look back options, Asian options and barrier options. This study will specifically look at the barrier family of exotic options on selected currencies.

Types ofBarrier Exotic Options Available:

The exotic option products offered by Forex Capital Markets include the following (forex-options.com):

One Touch Option:

This type of option is perfect for traders who anticipate a retracement and believe that the price of a given currency will test a support/resistance level. The One Touch option pays a fixed amount if the market touches the predetermined barrier level. Once the desired payoff, the currency pair, the barrier price, and the expiration date is determined, as long as the spot level hits the barrier level at least once prior to expiration, the payoff amount is received. If the barrier is not reached during the option period, the option expires worthless. The option’s payout is credited to the clients account at the option’s predetermined expiration time.

No Touch Option:

A No Touch option is a great way to profit from a trending market. The no-touch option pays a fixed amount if the market never touches the predetermined barrier level chosen. Once the desired payoff, the currency pair, the Barrier Price, and the expiration date are all determined, as long as the spot level never hits the barrier price before expiry, the payoff amount is determined. If the barrier is reached during the option period, the option expires worthless.

Digital Option:

Digital options are the most commonly used category of exotic options (Cotnas, 2003A). A Digital Option is designed specifically for traders who believe that the market will be above or below a certain level at some specified time, and is a great way to profit from a rally or a correction in the market. The digital option pays a fixed amount if the spot price is above or below the target level that is chosen. Once the desired payoff, the currency pair, the strike price, and the expiration date are determined, As long as the spot price is above or below the barrier level at expiration, the payout is received. In contrast to a "one-touch option," the payout of a digital option is only governed by the spot price prevailing at expiration. If the spot price is not above (in the case of a call) or below (in the case of a put) the specified barrier at the end of the option period, the option expires worthless. This means that a Digital Call Option would expire worthless if the spot price is lower than the strike price at time of expiry. A Digital Put Option would expire worthless if the spot price is higher than the strike price at the time of expiry.

Double One Touch Option:

A Double One-Touch option is a great way for traders to profit from a volatile market with significant up and down swings. The Double One-Touch option pays a fixed amount if the market touches one of the two specified spot prices (barrier levels) prior to expiration. Once the desired payoff is selected, the currency pair, the barrier prices, and the expiration date are all determined, as long as the Fixed Rate Options level hits one of the barrier levels prior to expiration, the payoff amount is received. If neither barrier is reached during the option period, the option expires worthless.

Double No Touch Option:

A Double No-Touch option is a great way for traders to profit from a less volatile market with insignificant up and down swings. The Double No-Touch option pays a fixed amount if the market does not touch either of the two specified spot prices (barrier levels) prior to expiration. Once the desired payoff is chosen, the currency pair, the barrier prices, and the expiration date are all determined, as long as the spot level does not hit either barrier level prior to expiration, the payoff amount is received. If one or both of the barriers are reached during the option period, the option expires worthless.

In this study we will restrict our scope to one touch call and put options, given the time constraints involved. European and exotic option calculators available at forex capital markets (forex-options.com) will be used as for calculating European and exotic option premiums. The exotic option prices on each one of the above options as calculated by the exotic option calculators will be compared against corresponding European on each of the selected currency crosses discussed earlier. For each currency cross both put and call prices at particular strike prices will be compared. Out of the money puts and calls will be chosen as exotic options are based on target prices being either triggered or not triggered.

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