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      This edition first published 2015

      © 2015 Jessica James, Jonathan Fullwood and Peter Billington

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      Library of Congress Cataloging-in-Publication Data

      James, Jessica, 1968–

      FX option performance: an analysis of the value delivered by FX options since the start of the market / Jessica James, Jonathan Fullwood, Peter Billington.

      pages cm. – (The wiley finance series)

      Includes index.

      ISBN 978-1-118-79328-2 (hardback) 1. Options (Finance) I. Fullwood, Jonathan, 1976– II. Billington, Peter, 1948– III. Title.

      HG6024.A3J355 2015

      332.64′53–dc23

      A catalogue record for this book is available from the British Library.

      ISBN 978-1-118-79328-2 (hbk) ISBN 978-1-118-79326-8 (ebk)

      ISBN 978-1-118-79327-5 (ebk) ISBN 978-1-118-79325-1 (ebk)

      Cover Design: Wiley

      Top Image: ©iStock.com/Maxiphoto

      Bottom Image: Gears ©iStock.com/Marilyn Nieves

      Business Graph: ©iStock.com/kickimages

      Certain figures and tables compiled from raw data sourced from Bloomberg

      About the Authors

      Prof Jessica James

      Jessica James is a Managing Director and Head of FX Quantitative Solutions at Commerzbank AG in London. She has previously held positions in foreign exchange at Citigroup and Bank One. Before her career in finance, James lectured in physics at Trinity College, Oxford. Her significant publications include the Handbook of Foreign Exchange, Interest Rate Modelling and Currency Management.

      Jessica is a Managing Editor for the Journal of Quantitative Finance, and is a Visiting Professor both at UCL and at Cass Business School. She is a Fellow of the Institute of Physics and has been a member of their governing body and of their Industry and Business Board.

      Dr Jonathan Fullwood

      Jonathan Fullwood began his career in finance in 2002 and has since held positions in research, sales and trading at Commerzbank AG in London. He was awarded a CFA charter in 2007 and remains a member of the CFA Institute.

      Before his career in finance he graduated with first class honours in physics from the University of Manchester, where he also worked as a mathematics tutor. Jonathan completed his particle physics doctoral thesis in 2001, on work carried out at the Stanford Linear Accelerator Centre.

      Peter Billington

      Peter Billington is Global Head of FX Exotic Options at UniCredit in London. Since 1993 he has worked in FX option trading roles for Standard Chartered Bank and BNP Paribas and has traded metals for Dresdner Kleinwort Wasserstein. He has also worked at Commerzbank AG in several positions, including that of Global Head of FX Trading.

      Prior to his career in finance, Peter read mathematics and then mathematical modelling and numerical analysis at the University of Oxford.

      CHAPTER 1

      Introduction

      1.1 WHY READ THIS BOOK?

      Let's be honest, there is no shortage of books on Foreign Exchange (FX) options. There are plenty of places, online and on paper, where you can read about how to value FX options and associated derivatives. You can learn about the history of the market and how different valuation models work. Regular surveys will inform you about the size and liquidity of this vast market, and who trades it.

      This is not what this book is about. This is about what happens to an option once it is bought or sold. It is about whether the owner of an option had cause to be happy with their purchase. It is about whether FX options deliver value to their buyers.

      In the financial markets, there is huge and detailed effort made to value contracts accurately at the start of their lives. Some decades ago this work was begun in earnest when Black and Scholes published their famous paper [1]. Perhaps indeed we could say it started in 1900 when Bachelier derived a very similar model [2] though this was not followed up on. But, in general, quantitative researchers in the markets and in universities spend long hours to devise ways of correctly valuing complex contingent deals under sets of assumptions which make the mathematics possible.

      But are these assumptions right, i.e. over time, do they turn out to have been correct? Bizarrely, they do not have to have been ‘correct’ to continue to be used; later in the book we will give some detailed examples of assumptions that turn out to be manifestly incorrect. For an option, we can say that in an efficient (‘correctly priced’) market, on average, we would expect an option to pay back the money it cost in the first place – less costs, of course.1 In this book we will use terms like ‘mispriced’ or ‘misvalued’

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