Barrier (European)

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A foreign exchange barrier option is a derivative financial instrument that provides investors with a flexible tool to hedge risks and realize returns in the foreign exchange market. This article will explore the basic structure of forex barrier options, their advantages, and their application in practical scenarios.

Option Structure

Foreign exchange barrier options are option contracts with barrier conditions. The key feature of this option is that when the underlying asset (usually the foreign exchange rate) reaches or exceeds a predetermined barrier level, the specific rights of the option will change. The main types of forex barrier options include:

Up and In: When the exchange rate rises to the preset level, the option becomes effective.
Up and Out: When the exchange rate rises to the preset level, the option becomes invalid.
Down and In: When the exchange rate drops to a predetermined level, the option becomes effective.
Down and Out: When the exchange rate drops to the preset level, the option becomes invalid.

Advantages

Flexibility

Foreign exchange barrier options provide investors with more flexibility. By setting barrier levels, investors can adjust their option structure based on their own risk preferences and market expectations. This flexibility makes forex barrier options an important tool in risk management and investment strategies.

Risk hedging

The establishment of barrier options enables investors to hedge risks more effectively. For example, Up and In options allow investors to participate in the market when it is moving in the direction they expect, while providing some protection when the market is moving in an unfavorable direction.

Low cost

Compared to some traditional option strategies, the structure of forex barrier options typically brings lower costs. This is an economically efficient choice for investors who wish to obtain certain specific rights in the market.

Application scenarios

Obstacle options trading case between enterprises and banks

Enterprise (Exporter Ltd.):
Exporter Ltd. is a manufacturer headquartered in the United States, mainly exporting automotive parts to Europe. Due to its business relationship, Exporter Ltd. needs to manage the exchange rate risk between the US dollar and the euro. In order to reduce the uncertainty caused by foreign exchange fluctuations, Exporter Ltd. is considering partnering with a bank to purchase barrier options.

Global Bank:
Global Bank is an international bank that provides various financial services, including foreign exchange risk management. It has a long-term business partnership with Exporter Ltd. and is willing to provide customized barrier option contracts for it.

Obstacle option contract structure:

Obstacle level:
Exporter Ltd. and Global Bank jointly determine the barrier level, which is the level at which the exchange rate touches the period when the option becomes effective or invalid. Assuming the barrier level they set is 1.15, that is, when the euro to dollar exchange rate reaches or exceeds 1.15, the option becomes effective.
Option type:
They chose the Up and In barrier option, which means that the option will only take effect when the euro to dollar exchange rate rises to or above the set barrier level.
Contract amount:
Exporter Ltd. pays a certain contract amount to Global Bank as the cost of purchasing barrier options.
Option Term:
The contract specifies the term of the option, assuming it is 6 months.

The impact of price changes on the expiration date on the results:

The exchange rate has not reached the barrier level:
If the euro to dollar exchange rate does not reach or exceed the set barrier level (i.e. still below 1.15) at the expiration date, the Up and In barrier option will become invalid. Exporter Ltd. lost the cost of purchasing the option in this situation, but gained some insurance effect because the option did not take effect.
Exchange rate reaches barrier level:
If the euro to dollar exchange rate reaches or exceeds the set barrier level (i.e. 1.15) at the expiration date, the option will take effect. Exporter Ltd. will receive a payment, which may be a predetermined percentage, such as twice the contract amount. This helps offset the cost increase caused by unfavorable exchange rate fluctuations.

Result analysis:

The exchange rate has not reached the barrier level:
Exporter Ltd.： Losing the cost of purchasing options, but gaining a certain degree of risk protection.
Global Bank： Obtained option fees but did not provide payment.
Exchange rate reaches barrier level:
Exporter Ltd.： Obtaining a payment helps to hedge against cost pressures caused by unfavorable exchange rate fluctuations.
Global Bank： The option fee was paid because the option became effective.

Through the structure of this barrier option, Exporter Ltd. is able to obtain a certain level of protection and flexibility in different market scenarios, while Global Bank provides personalized services to customers by offering innovative financial tools while earning option fees. In practical operation, this structure can help enterprises better manage foreign exchange risks and improve the sustainability of their international business.

Explanation of Barrier Options by the Foreign Exchange Trading Center

Knock in/Knock out Options
The option is initially valid or invalid. When the observed value on the expiration date is higher or lower than the agreed barrier price, the option automatically becomes invalid or effective. If the option becomes effective, it is equivalent to a regular European option and is divided into strike options and strike options.

The reference exchange rate can be based on the benchmark price published by the trading center. At present, the foreign currency pair (G10) market supports selecting benchmark prices at 10:00, 11:00, 14:00, 15:00, and 16:00 as reference exchange rates.

Note:

There are eight types of obstacle options based on the combination of strike/strike, call/put, and obstacle direction.
The trading rules for obstacle options are the same as those for regular European options, with the only difference being the treatment of option expiration dates: based on the type of obstacle, obstacle value, and tracked benchmark price, the validity of the option is first determined. If it is valid, then the option is the same as regular European options, allowing the option buyer to exercise at the exercise price before the exercise deadline. The specific judgment relationship is shown in the table below:

Barrier Options	Barrier Direction	Relationship between Reference Exchange Rate and Barrier Price	Option Status	MCP Correspondence (BarrierType)
Knock in	UP	Reference rate>Obstacle prices	effective	KNOCK_UP_IN
Knock in	UP	Reference rate<=Obstacle prices	invalid	KNOCK_UP_IN
Knock in	DOWN	Reference rate>=Obstacle prices	invalid	KNOCK_DOWN_IN
Knock in	DOWN	Reference rate<Obstacle prices	effective	KNOCK_DOWN_IN
Knock out	UP	Reference rate>Obstacle prices	invalid	KNOCK_UP_OUT
Knock out	UP	Reference rate<=Obstacle prices	effective	KNOCK_UP_OUT
Knock out	DOWN	Reference rate>=Obstacle prices	effective	KNOCK_DOWN_OUT
Knock out	DOWN	Reference rate<Obstacle prices	invalid	KNOCK_DOWN_OUT

At present, European barrier options and European digital options only support the foreign currency pair (G10) market.

Extract：P51，Product Guidelines of China Foreign Exchange Trading Center V4.2.pdf

Reference Pricing Principle