A EUR/USD option is a type of FX option. In order to determine the Put/Call options cost – we need to understand what an FX option is and the many factors that play a role in determining the cost of a particular put/call option.

What do you mean by an “FX option”?

In financial terms, a foreign exchange option is a derivative financial asset. It confers the right upon the holder to trade money expressed in one currency into another at a predetermined exchange rate on a set date.

To fully grasp a foreign exchange option, you must be familiar with four key economic terms. The currency pair, the notional, the term, and the strike rate.

Currency pair. This refers to the currency pair elected by the holder. The pair comprises a currency to sell (put currency) and another currency to purchase (call currency).

National. The amount covered by the option is what we refer to as the notional. In an FX option contract, traders can prearrange and fix the put/call currency amount.

Term. This is the duration for which the FX option is valid. On the expiry date, the holder gets to exercise his right and exchange an amount of currency at the strike rate (explained below). Please bear in mind that delivery of the amounts can take up to two days.

Strike rate. The strike rate is the pre-agreed rate at which the option holder has the right to exchange the currency. Furthermore, it is a measurement of the spot/ forward rate.

Factors Determining the Put/Call Options Cost

One will be needing a premium to buy a FX Option. An intrinsic value and time value are the two components that make up the premium.

In other words, an FX option premium = intrinsic value + time value

When forward rate and strike rate are used to convert the amounts, the difference between both converted amounts is the intrinsic value. Under it, an assumption regarding the option is made; that is, it is executed on the day and time of calculation. The payout, in this case, is calculated in the form of intrinsic value.

Then we have time value, which is the value of money associated with the remaining time before the expiry of the contract. Factors such as term, strike rate, exercise style, and volatility are capable of influencing its final value. Let us define each factor determining the put/call options cost below:

Term – Increasing the duration of the term increases the time value.

Strike rate – If the strike rate is more favourable to the option holder, the time value will be greater because the likelihood of the option having a positive outcome is much higher.

Volatility – If the currency pair has higher volatility, then the time value will also be greater.

Exercise style – The more “optionality” there is in a particular exercise style (American/European/Bermuda), the greater the time value will be when taking that route.