Why does an increase in the volatility of foreign exchange rates increase the value of foreign currency options?
What will be an ideal response?
The easiest way to understand how an increase in variance affects option prices is to place the strike price of a call option at the conditional mean of two probability distributions, one with a low variance and the other with a high variance. The increase in the variance of the possible future exchange rate clearly increases the possible range of future exchange rates. But, because the conditional mean is the same, the probability that the option will finish in the money is still one-half because one-half of the probability distribution remains above the strike price. However, if the option does finish in the money, the distribution with the larger variance yields possibly larger payoffs, and the option will cost more. A symmetrical argument can be applied to a put option.
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What will be an ideal response?
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