Understanding Time Options in Foreign Exchange using Excel

Time options are a type of foreign exchange option that gives the buyer the right, but not the obligation, to exchange one currency for another at a specified exchange rate on or before a specified date. Time options are different from regular options, which can only be exercised on a specific date. Time options offer more flexibility and can be used to hedge against exchange rate fluctuations over a period of time.

For example, suppose you are a U.S. importer who needs to pay 100,000 euros to a European supplier in three months. You are worried that the euro might appreciate against the U.S. dollar in the meantime, making your payment more expensive. To hedge your risk, you buy a time option that gives you the right to sell $120,000 and buy 100,000 euros at an exchange rate of 1.20 USD/EUR anytime within the next three months. This way, you lock in the maximum amount of dollars you need to pay for your euros, regardless of how the exchange rate moves. If the euro appreciates above 1.20 USD/EUR, you can exercise your option and save money. If the euro depreciates below 1.20 USD/EUR, you can let your option expire and buy euros at the lower spot rate.

Time options are also known as American options, because they can be exercised at any time before expiration, unlike European options, which can only be exercised at maturity. Time options are usually more expensive than regular options, because they offer more flexibility and value to the buyer. Time options are traded over-the-counter (OTC), meaning they are customized contracts between two parties and are not standardized or regulated by an exchange.

Basic Theory:

Time options, also known as time value options or simply time options, are derivative contracts that grant the holder the right, but not the obligation, to buy or sell a specified amount of a currency at an agreed-upon exchange rate within a predetermined period. These options derive their value from both intrinsic value (the difference between the current exchange rate and the strike price) and time value (the remaining time until expiration).

Procedures:

1. Identify the Components:
   • Currency Pair: Specify the currencies involved (e.g., USD/EUR).
   • Strike Price: The agreed-upon exchange rate.
   • Expiry Date: The date until which the option is valid.
2. Determine Option Type:
   • Call Option: The right to buy the currency at the strike price.
   • Put Option: The right to sell the currency at the strike price.
3. Calculate Intrinsic Value:
   • For a call option: Max(0, Spot Price – Strike Price)
   • For a put option: Max(0, Strike Price – Spot Price)
4. Compute Time Value:
   • Time Value = Option Price – Intrinsic Value
5. Create Excel Table:
   • Set up columns for Spot Price, Strike Price, Expiry Date, Option Type, Option Price, Intrinsic Value, Time Value, and Total Value.

Scenario:

Consider a scenario where you purchase a call option for USD/EUR with the following details:

• Strike Price: 1.15
• Option Price: $0.03
• Spot Price: 1.12
• Expiry Date: 30 days

Calculation:

1. Intrinsic Value:
   • Intrinsic Value = Max(0, 1.12 – 1.15) = 0
2. Time Value:
   • Time Value = $0.03 – 0 = $0.03
3. Total Value:
   • Total Value = Option Price = $0.03

Excel Table:

Other Approaches:

1. Delta Hedging: Adjust the position in the underlying currency to neutralize the delta, reducing risk.
2. Greeks Analysis: Evaluate the option’s sensitivity to changes in various factors such as price, time, and volatility.
3. Monte Carlo Simulation: Use simulations to model the potential outcomes under different market conditions.