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'Ordering' the Two Currencies

All option pricing models require that we nominate one of the currencies to be the 'domestic' (or denominated) currency. Once this choice is made, the other currency is set to be the 'foreign' currency. In effect, the option is valued by taking the foreign currency to be the underlying asset (which will either be bought or sold if the option is exercised) and the strike can then be thought of as the contract price of the underlying asset. This obviously has a direct effect on the way in which the spot exchange rate is quoted: the valuation formula requires that the spot rate be quoted as the number of units of the domestic CCY that must be paid for each unit of the foreign CCY. Again, if we think of 1 unit of the foreign CCY just like any other asset, the spot rate can be thought of as the current cost of that asset.

 

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