Quick Answer
Foreign currency options cover 10,000 units of currency (1,000,000 yen), are European-style, and generally settle by physically delivering the currency. Yield-based options track Treasury yields, are European-style, settle in cash, and move opposite to bonds: a long call profits when rates rise and bond prices fall.
Most of what you've learned so far applies to equity options (options on individual stocks). But the Series 7 also tests two specialized categories: foreign currency options and yield-based (interest rate) options. Each has unique contract specifications and requires understanding the inverse relationship between yields and bond prices.
How Do Foreign Currency Options Work?
Foreign currency options give the holder the right to buy or sell a specific amount of foreign currency at a set exchange rate.
What Are the Contract Specifications for Foreign Currency Options?
| Specification | Detail |
|---|---|
| Contract size | Standard convention is 10,000 units of the foreign currency (Japanese yen: 1,000,000 yen); the exact unit is set by the listing market |
| Premium multiplier | 100 |
| Exercise style | European-style (exercise at expiration only) |
| Settlement | Generally physical delivery of the underlying currency; some series are cash-settled instead |
| Expiration | Third Friday of the expiration month |
| Quotation | Premiums quoted in U.S. cents per unit of foreign currency |
What Is the Directional Logic for Foreign Currency Options?
- A call on a foreign currency = right to buy the foreign currency
- Bullish on the foreign currency / bearish on the U.S. dollar
- A put on a foreign currency = right to sell the foreign currency
- Bearish on the foreign currency / bullish on the U.S. dollar
Common currencies: British pound, Canadian dollar, Australian dollar, Swiss franc, euro, Japanese yen
Remember: A foreign currency option generally settles by physical delivery of the underlying currency, though some series are cash-settled instead, so read the series specifications. Under physical delivery, exercising a call means paying U.S. dollars to receive the foreign currency at the strike rate; exercising a put means delivering the foreign currency and receiving U.S. dollars. This is the key contrast with index options, which always settle in cash.
Exam Tip: Gotchas
- Foreign currency options are European-style, and most settle by physical delivery. European-style means exercise at expiration only, yet unlike most European-style options, these typically settle with actual currency delivery (not cash); a minority are cash-settled.
- Japanese yen contract size is 1,000,000; other commonly tested currencies use 10,000 units as the standard convention.
- Both foreign currency and yield-based options are European-style. This is an easy detail to overlook.
How Do Yield-Based (Interest Rate) Options Work?
Yield-based options are based on the yield (not the price) of U.S. Treasury securities. This distinction creates an inverse relationship worth understanding well.
What Are the Contract Specifications for Yield-Based Options?
| Specification | Detail |
|---|---|
| Underlying | Yield on U.S. Treasury securities (13-week T-bill, 5-year T-note, 10-year T-note, 30-year T-bond) |
| Strike price | Represents a yield (move decimal one place left: strike of 35 = 3.5% yield) |
| Contract multiplier | $100 is the standard; Cboe fixes 100 for its interest rate contracts, but different yield-based series may carry a different multiplier |
| Exercise style | European-style |
| Settlement | Cash settlement |
How Do Yields and Bond Prices Move Inversely?
Since yields and bond prices move inversely, the directional logic is reversed from what you might expect:
| Position | Profits When | Equivalent Bond View |
|---|---|---|
| Long yield-based call | Yields rise | Bearish on bond prices |
| Long yield-based put | Yields fall | Bullish on bond prices |
- A long yield-based call hedges a bond portfolio against rising interest rates: as rates rise, the call gains value to offset bond losses
- A long yield-based put profits when yields fall (bond prices rise)
Exam Tip: Gotchas
- Yield-based options move with YIELDS, not prices. A long call on yield-based options profits when rates rise (opposite of a long call on a bond).
- "Call on yield = rates up = bond prices down." This inverse relationship is the key takeaway.
- Strike price of 35 on a yield-based option = 3.5% yield. Move the decimal one place left to convert.
What Should You Check on Exam Day?
- Both foreign currency and yield-based options are European-style, exercisable only at expiration
- Foreign currency options generally settle by physical delivery, with some cash-settled series; yield-based options always settle in cash
- Japanese yen contracts cover 1,000,000 yen; every other currency covers 10,000 units
- Yield-based options move with yields: a long call profits when rates rise (bond prices fall)