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HEDGING FOREIGN CURRENCY RISK: OPTIONS

HEDGING FOREIGN CURRENCY RISK: OPTIONS.

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HEDGING FOREIGN CURRENCY RISK: OPTIONS

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  1. HEDGING FOREIGN CURRENCY RISK: OPTIONS

  2. …the options markets are fertile grounds for imaginative, quick thinking individuals with any type of risk profile. The possibility set is limited only by the creativity of the participants…Huge growth in derivatives markets: from 250,000,000 contracts in 1988 to 1,630,000,000 contracts in 2009.

  3. Currency options • Currency options began trading on the Philadelphia Stock Exchange (PHLX) in 1982 • More option exchanges around the world, • more currencies and debt instruments on which options are traded • option contracts with longer maturities • more “styles” of option contracts, and • greater volume of trading activity

  4. Types of contracts • A call optionbestows on the owner the right, but not the obligation, to buy the underlying financial asset or commodity. • A put optionconveys to the owner the right, but not the obligation, to sell the underlying financial asset or commodity. • A European optioncan be exercised once only at the maturity date of the option. • An American optioncan be exercised at any time on or before the maturity date.

  5. Why options? While foreign currency options and futures are largely similar - they trade on organized exchanges at pre-specified quantities and maturities - they differ in up to three main ways: 1. The holder of an option has the right but not the obligation to trade currencies at a pre-specified rate at some future date; with futures contracts, holders are required to exchange currencies. 2. While there exists a single rate at which parties in a futures contract agree to exchange currencies in the future, the pre-specified option exchange rate can be selected from any of a number of possible rates (known as ‘strike-prices’).

  6. Why options? 3. While futures contracts allow for the exchange of currencies only at the maturity date, some option contracts (know as ‘American-style’ options) allow the holder to trade at the strike price at any time up to the maturity date. The major benefit of using options in hedging is that they can be used to hedge potential transactions, or transactions that are contingent upon something else.

  7. Types of contracts Examples • An American call option on spot € : • The right to buy € 1 million for $1.10 per € from today until expiration on Dec 15, 2006. • This “call on € ” is also a “put on US$”. • A European put option on Swiss franc: • The right to sell SFr 10 million March 2002 for $0.65 per SFr on (and only on) Mar 15, 2002. • This “put on SFr” is also a “call on US$”.

  8. Financial Times, June 21, 2000  PHILADELPHIA SE EURO/$ OPTIONS €62,500 (cents per €) Strike Price CALLS PUTS Jul Aug Sep Jul Aug Sep 0.940 0.960 0.980 2.44 3.04 3.62 1.23 1.89 2.49 0.53 1.15 1.62 0.46 0.86 1.26 1.19 1.67 2.07 2.38 2.78 3.19 Previous day’s vol., Calls 265 Puts 28. Prev. day’s open int., Calls 4,111 Puts 888 Consider the August 2000 €/$ call option with a strike price of $0.96. The closing price was $0.0189 per €. Contract specifications The buyer of this call option would expect to pay 62,500  $0.0189 = $1,181.25 plus commission charges.

  9. European Call and Put The holder of a EUROPEAN CALL option has the RIGHTbut not the obligation to buycurrencies at a pre-specified rate (STRIKE PRICE) at some future date (EXPIRATION DAY). M = size of position c = call price cT = European call payoff X = strike price T = expiration day S0 = spot exchange rate today ST = spot exchange rate at expiration day

  10. European Call and Put From the Financial Times: $62,500 Euro - European Style Expiring in May and a strike price of $1.65. c = 0.0081 $ per Euro of contract X = 1.650 $/Euro T = today - May S0 = 1.6214 $/Euro M = 62,500 Euro

  11. European Call and Put Payoff = cT = ??? What if ST = 1.700 $/Euro? Exercise call (buy 62,500 Euros buy paying 1.650 $ per Euro). Payoff = 62,500 * (1.700 - 1.650) = 3,125$ Profit = 3,125 - 62,500 * 0.0081 = 2,618.75$

  12. European Call and Put Payoff = cT = ??? What if ST = 1.600 $/Euro? Do not exercise call. If you do, you end up with losses. Payoff = 0$ Profit = 0 - 62,500 * 0.0081 = - 506.25 $ Loss = 506.25$

  13. European Call and Put Payoff = cT = ??? What if ST = 0.600 $/Euro? Do not exercise call. If you do you end up with losses. Payoff = 0$ Profit = 0 - 62,500 * 0.0081 = - 506.25 $ Loss = 506.25$ Payoff= cT = M * max [ 0 , ST - X ] Profit = M * ( max [ 0 , ST - X ] - c )

  14. Long foreign currency call Profit or Loss 0

  15. Long foreign currency call Profit or Loss X 0 S Strike Price

  16. Long foreign currency call Profit or Loss X 0 S Value of exchange rate at expiration day

  17. Long foreign currency call Profit or Loss X 0 S Risk of Loss ST < X Profit = - M * c

  18. Long foreign currency call Profit or Loss X Possible Profit 0 S ST > X Profit = M * [( ST - X ) - c]

  19. Long foreign currency call Profit or Loss X Possible Profit 0 S Risk of Loss ST < X ST > X Profit = M * ( max [ 0 , ST - X ] - c )

  20. European Call and Put The holder of a EUROPEAN PUT option has the RIGHT but not the obligation to short currencies at a pre-specified rate (STRIKE PRICE) at some future date (EXPIRATION DAY). pT = M * max [ 0 , X - ST ] Profit = M * ( max [ 0 , X - ST ] - p )

  21. Long foreign currency put Profit or Loss X 0 S

  22. Long foreign currency put Profit or Loss X Possible Profit 0 S ST < X Profit = M * [( X - ST ) - p]

  23. Long foreign currency put Profit or Loss X 0 Risk of Loss S ST > X Profit = - M * p

  24. Long foreign currency put Profit or Loss X Possible Profit 0 Risk of Loss S ST < X ST > X Profit = M * ( max [ 0 , X - ST ] - p )

  25. Short foreign currency call Profit or Loss 0 S X

  26. Short foreign currency call Profit or Loss Possible Profit 0 S Risk of Loss X ST < X Profit = M * c

  27. Short foreign currency call Profit or Loss 0 S Risk of Loss X ST > X Profit = - M * max [ 0 , ST - X ]

  28. Short foreign currency call Profit or Loss Possible Profit 0 S Risk of Loss X ST < X ST > X Profit = - M * ( max [ 0 , ST - X ] - c )

  29. Short foreign currency put Profit or Loss 0 S X

  30. Short foreign currency put Profit or Loss 0 S X ST < X Risk of Loss Profit = - M * max [ 0 , X - ST ]

  31. Short foreign currency put Profit or Loss Possible Profit 0 S X ST > X Profit = M * p

  32. Short foreign currency put Profit or Loss Possible Profit 0 S X ST < X Risk of Loss ST > X Profit = - M * ( max [ 0 , X - ST ] - p)

  33. Option which would generate profit if exercised immediately is said to be in the money.

  34. In the money:St>X for Calls and St<X for Puts.

  35. In the money:St>X for Calls and St<X for Puts. • Option which would generate zero profit if exercised immediately is said to be at the money.

  36. In the money:St>X for Calls and St<X for Puts. • At the money:St=X for Calls and St=X for Puts.

  37. In the money:St>X for Calls and St<X for Puts. • At the money:St=X for Calls and St=X for Puts. • Option which would generate losses if exercised immediately is said to be out of the money.

  38. In the money:St>X for Calls and St<X for Puts. • At the money:St=X for Calls and St=X for Puts. • Out of the money:St<X for Calls and St>X for Puts.

  39. How does it compare to Forwards? Remember that Forward is the obligation to long or short currency at some pre-specified price at some future date. Option is the right to long or short currency at some pre-specified price at some future date. You do not pay anything for the forward contract! But you have to pay for the option! Why? You need to pay for the right!

  40. How does it compare to Forwards? Profit or Loss Long forward S X Remember that long forward payoff looks like

  41. How does it compare to Forwards? Profit or Loss 0 S X What if we long call...

  42. How does it compare to Forwards? Profit or Loss Long call 0 S X What if we long call...

  43. How does it compare to Forwards? Profit or Loss Short put 0 S X What if we long call and short put with identical strikes and expiration dates?

  44. How does it compare to Forwards? Profit or Loss Long call Short put 0 S X What if we long call and short put with identical strikes and expiration dates?

  45. How does it compare to Forwards? Long Forward = { long call + short put } What if we long call and short put with identical strikes and expiration dates?

  46. How does it compare to Forwards? Profit or Loss Long forward 0 S X Remember that long forward payoff looks like

  47. How does it compare to Forwards? Profit or Loss Short forward 0 S X Remember that short forward payoff looks like

  48. How does it compare to Forwards? Profit or Loss 0 S X What if we short call ...

  49. How does it compare to Forwards? Profit or Loss 0 S X What if we short call and long put with identical strikes and expiration dates?

  50. How does it compare to Forwards? Profit or Loss 0 S X What if we short call and long put with identical strikes and expiration dates?

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