How is the Value of a Currency Option Determined?
The simple answer to this question is “by market participants.” Options, like other assets, are purchased and sold by market players. Options are usually bought and sold by market makers who then provide a bid and offer price to investors. Determining the value of an option can be slightly more complicated.
There are several components to an option. To find the value of an option, you are looking for the probability that the option will be “in the money” on the expiration date. The probability that an option will be either above or below the strike price on or before expiration, requires several variables as well as an option pricing model. The Black-Scholes pricing model is the standard in the industry.
Don’t worry, you do not need to know the intricate mathematical calculations to understand how to value an option. What you do need to understand is the inputs that are used in the model. The most important inputs are the current exchange rate of the currency pair, the strike price, the expiration date, as well as the implied volatility.