Touch/No-Touch Option
FinPricing offers:
Four user interfaces:
- Data API.
- Excel Add-ins.
- Model Analytic API.
- GUI APP.
Touch Option Introduction and Pricing Guide
FinPricing provides valuation tools for the following touch products:
- One Touch Up
- One Touch Down
- No Touch Up
- No Touch Down
- Touch Rebate Option
- No Touch Rebate Option
- Double No Touch (DNT) Option
- Double One Touch (DOT) Option
- Multiple Windows No Touch Option
- Multiple Windows Touch Option
- Check Related Barrier Options
- Check FinPricing valuation models
| 1. Touch Option Introduction |
A touch option is the sort of FX option that promises a payout once the price of
an underlying asset reaches or passes a predetermined level. Touch options allow investors to choose the target price,
time to expiration, and the premium to be received when the target price is reached.
There are only two possible outcomes. If the barrier is broken a trader will receive the agreed full payout.
If the barrier isn’t broken, the trader will lose the premium paid to the broker. Unlike vanilla
FX call options and FX put option,
touch options allow investors to profit from a simplified yes-or-no market forecast. Like regular
FX call option and FX put options, most touch option trades can
be closed before expiration for a profit or a loss depending on how close the underlying market or asset is to the
target price.
This type of option is popular with traders who believe the price of an underlying asset will pass a certain level
in the future, and for those who aren’t sure whether the higher price level is a sustainable one. Speculative market
participants like to use touch options as bets on a rising or falling exchange rate.
Clients, who prefer to hedge, trade touch options as a rebate in order to secure themselves compensation in case
their strategy doesn’t work out. Touch options are also often integrated into structured products to increase returns
on forward and interest rates. They become especially useful during times of market volatility when prices might be
uncertain.
An investor who chooses no touch option type is trading on the assumption that the price of their selected asset will
fail to reach a specific level before the end of the expiry period. The investor may trade touch options, if he believe
that the price of their selected asset will reach a specific level before the end of the expiry period.
Touch rebate options are characterized by one or two barrier levels, as well as by a cash rebate associated with crossing the barrier. Their payoff depends on whether the FX spot rate ever crosses the barrier level during the specified period of the option. Based on this period, touch rebate options come in three types: American, European, and partial window. Each type has eight different payoff functions: one touch up/down, no touch up/down, double no touch, double one touch, one touch up/down no touch down/up. The American type is the most popular one in the market.
The barriers of a touch option can be continuous or discrete. The touch rebate
options have three different types: European type, American type, and partial window
type. Most of the touch rebate options in the market are of the American type. Each
barrier type has eight different payoff functions.
If you are using a close-form solution, i.e., modified Black-Scholes, you may need to apply Vanna-Volga adjustment
to the Black-Scholes theoretical value. One way to look at this is that it tries to correct for the impact of the smile
on the B-S price. It is based on the construction of locally replicating portfolios whose associated hedging
costs are added to corresponding B-S prices to produce smile-consistent values. In practice, Vanna-Volga pricing does
a very good job of matching the market by virtue of the necessary substantial tuning.
If you are using an advanced numerical solution that captures volatility skew, the Vanna-Volga adjustment is not needed.
| 2. Forex Market Convention |
One of the biggest sources of confusion for those new to the FX market is the market convention. We need to make clear the meaning of the following terms in the forex market first.
- FX quotation: The quotation EUR/USD 1.25 means that one Euro is exchanged for 1.25 USD. Here EUR (nominator) is the base or primary currency and USD (denominator) is the quote currency. One can convert any amount of base currency to quote currency byQuoteCurrencyAmount = FxRate * BaseCurrencyAmount
- Spot Date: The spot date or value date is the day the two parties actually exchange the two currencies. In other words, a currency pair requires a specification of the number of days between the quotation date (trade date) and the Spot Date on which the exchange is to take place at that quote. Spot days can be different for each currency pair, although typically it is two business days.
- Holidays: Each currency pair has a set of holidays associated with it. The holidays of a currency pair is the union of the holidays of the two currencies.
- FX curves: The observed curves in the FX market are FX forward points/spreads that cannot be used to price a FX trade directly. One needs to bootstrap FX forward points into FX yield curves in order to conduct valuation. Note that FX yield curves are quite different from LIBOR yield curves or government yield curves. Find more details about FX curves.
| 3. Payoffs and Conditions |
Depending on the barrier types, the touch option can be divided into the following categories. The barrier conditions for different types of touch options are given by
The payoff currency could be either the cash (base) or the asset (underlying).
| 4. Related Topics |