Which of the following statements is correct?
- The option which costs 2.85% is an EUR put
- The option which costs 4.83% is a USD call
- The option which costs 2.85% is an EUR call
Answer:
1 Correct. The spot rate in EUR/USD is expressed as number of dollars per euro. With equal interest rates, the forward rate of EUR/USD will be identical to spot. The option with a price of 2.85%, the cheaper option, must be OTM. At 1.1800, euro would be worth less (USD 1.1800) than it is now (USD 1.2050). Consequently, the cheaper of the two options is the right to sell euro for dollars at a worse price than is currently available. Therefore, the option that costs 2.85% is an EUR put/USD call.
FX Volatility Smiles
Volatility smile in the FX option market is largely based on the fat-tails phenomenon. There are more extreme price movements than are suggested by the distribution in the standard pricing models. Volatility smiles are so deeply embedded in the FX world that the option market has two prices describing the smile for each maturity.