Pricing an FX option: how to check the premium you are charged
Six inputs go into an FX option premium. Five can be checked in minutes. The sixth explains almost all of the gap between the theoretical price and the price billed.
An FX option gives you the right, without the obligation, to exchange an amount at a fixed rate. It is the only instrument that protects on the downside while leaving the upside open, and that is why it is paid for — as a premium.
That premium can be computed. Six inputs go into it, and the fact that they are not equally verifiable explains most of what is at stake.
The six inputs, in order of verifiability
| Input | What it is | Can you check it? |
|---|---|---|
| Spot rate | The market mid rate at the time of quotation | Immediately |
| Strike | The rate at which you can exercise | It is on the proposal |
| Maturity | The life of the option | It is on the proposal |
| Base-currency rate | The euro interest rate over the period | Public market data |
| Quote-currency rate | The other currency's interest rate | Public market data |
| Implied volatility | The range of movement the market expects | Hardly — and that is the whole point |
This is the central asymmetry of the FX option market for a company. You can check five inputs, find them all correct, and still pay a premium materially above the market price — because the volatility used to compute it is not the one the bank itself pays.
The model: Garman-Kohlhagen
The reference model in FX is Garman-Kohlhagen, an adaptation of Black-Scholes that accounts for both interest rates of a currency pair — which Black-Scholes, designed for equities, does not.
You do not need to solve it by hand. What matters is what each input does to the price:
- The longer the maturity, the higher the premium: the market has more time to move.
- The higher the implied volatility, the higher the premium: the expected range is wider.
- The further the strike sits from the current rate in the direction that protects you, the lower the premium: protection starts further away.
- The two interest rates shift the reference forward rate, and therefore the point around which the option is valued.
The three-question test
- 1What volatility did you use?
Ask directly, and the answer must be a number. A bank quoting an FX option knows that value: it is at the heart of its own calculation. A refusal or an evasive answer is itself information.
- 2What is the plain forward price on the same notional and maturity?
It gives you the benchmark. An option necessarily costs more than a forward, since it leaves the upside open. But the gap between the two can be quantified, and it should stay proportionate to the protection actually obtained.
- 3What happens to the premium if I move the strike by 1 %?
Ask for two or three quotes at different strikes. How the premium moves reveals the consistency of the quotation: a premium that barely moves when the strike moves a lot signals a generously chosen volatility.
Why companies overpay on optional products
Three reasons combine, and none of them is a mystery.
- The premium is a single amount, paid once. Psychologically it compares to an insurance cost, not to a market price — and few people haggle over an insurance premium to the cent.
- Volatility is not a figure companies follow. They follow exchange rates, which they see every day, not implied volatility, which they never see.
- The option is often presented as the « prudent » product, as opposed to barrier structures. That framing is accurate on risk, and it disarms the conversation about price.
The right reflex is not to give up on options: on a conditional flow — a tender not yet won, an order subject to conditions — they remain the only suitable instrument, because their maximum loss is bounded by the premium. The right reflex is to pay the right price for them.
The case of « free » options
When a proposal combines a bought option and a sold option so that the premiums offset, you get a collar or a participating forward. The absence of a premium does not remove the calculation: it moves it. Each leg keeps a value of its own, and the gap between them is the bank's remuneration.
This is the case where checking has the most value, precisely because no money changes hands and nothing invites you to check.
Recompute the premium you are quoted
The pricer values your option with Garman-Kohlhagen from market data and shows the gap with the premium billed.
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Frequently asked questions
The questions finance departments ask most often on this topic
How is an FX option priced?
Through the Garman-Kohlhagen model, which adapts Black-Scholes to FX by incorporating both currencies' interest rates. The six inputs are spot, strike, maturity, both interest rates and implied volatility. The first five can be checked quickly; the last is the one that drives most of the price.
What is implied volatility and why is it decisive?
It is the range of movement the market expects on the pair until maturity, as it emerges from quoted prices. It is decisive because the premium is highly sensitive to it and because a company generally has no access to the levels quoted between banks: it is therefore the input where a gap most easily goes unnoticed.
Does an FX option cost more than a forward contract?
Yes, necessarily, because it delivers something more: it protects on the downside while leaving the upside open, whereas a forward fixes the rate both ways. The useful question is not whether it costs more, but whether the gap between the two is proportionate to the protection actually obtained — which can be quantified.
When is an option preferable to a forward contract?
Mainly on conditional flows: a tender not yet awarded, an order subject to conditions, an uncertain volume. A firm forward on a flow that does not materialise becomes an open position, whereas an option not exercised costs only its premium. It is a question of the nature of the flow, not of a market view.
Can you find out the volatility your bank used?
You can ask, and the question is legitimate since it sits at the heart of the calculation the bank has just done. You can also reconstruct it: starting from the premium quoted and the five other inputs, it is possible to back out the volatility that produces exactly that price, then compare it with market levels. That is what our pricer does.
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