HEDGING FOREIGN CURRENCY RISK: OPTIONS

11

HEDGING FOREIGN CURRENCY RISK: OPTIONS

22

…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.

33

Currency options

Currency options began trading on the Philadelphia Stock Exchange (PHLX) in 1982More 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

44

Types of contracts

A call option bestows on the owner the right, but not the obligation, to buy the underlying financial asset or commodity.A put option conveys to the owner the right, but not the obligation, to sell the underlying financial asset or commodity.A European option can be exercised once only at the maturity date of the option.An American option can be exercised at any time on or before the maturity date.

55

Why options?

66

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.

77

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$”.

88

Contract specifications

The buyer of this call option would expect to pay 62,500 $0.0189 = $1,181.25 plus commission charges.

99

European Call and Put

1010


1111


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$

1212


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$

1313


1414

Long foreign currency callProfit or Loss

0

1515

X

S

Strike Price

Profit or Loss

0

Long foreign currency call

1616

X

S

Value of exchange rateat expiration day

Profit or Loss

0


1717

X

SRisk of Loss

ST < X

Profit or Loss

0


1818

X

S

Possible Profit

ST > X

Profit or Loss

0


1919

0

X

SRisk of Loss

Possible Profit

ST < X ST > X

Profit or Loss


2020


2121

Long foreign currency put

0

X

S

Profit or Loss

2222

0

X

S

Possible Profit

ST < X

Profit or Loss


2323

0

X

SRisk of Loss

ST > X

Profit or Loss


2424

0

X

SRisk of Loss

Possible Profit

ST < X ST > X

Profit or Loss


2525

Short foreign currency call

0

XS

Profit or Loss

2626

0

XS

Risk of Loss

Possible Profit

ST < X

Profit or Loss


2727

0

XS

Risk of Loss

ST > X

Profit or Loss


2828

0

XS

Risk of Loss

Possible Profit

ST < X ST > X

Profit or Loss


2929

Short foreign currency put

0

XS

Profit or Loss

3030

Profit or Loss

0

XS

Risk of Loss

ST < X


3131

Profit or Loss

0

XS

Possible Profit

ST > X


3232

Profit or Loss

0

XS

Risk of Loss

Possible Profit

ST < X

ST > X


3333

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

3434

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

3535


•Option which would generate zero profit if exercised immediately is said to be at the money.

3636


•At the money: St=X for Calls and St=X for Puts.

3737



•Option which would generate losses if exercised immediately is said to be out of the money.

3838



•Out of the money: St<X for Calls and St>X for Puts.

3939

How does it compare to Forwards?

4040

Profit or Loss

XS

Remember that long forward payoff looks like

Long forward


4141

Profit or Loss

0

XS

What if we long call...


4242

Profit or Loss

0

XS

What if we long call...

Long call


4343

Profit or Loss

0

XS

What if we long call and short put with identical strikesand expiration dates?

Short put


4444

Profit or Loss

0

XS


Long call

Short put


4545


Long Forward = { long call + short put }


4646

Profit or Loss

XS

Remember that long forward payoff looks like

Long forward

0


4747

Profit or Loss

0

XS

Remember that short forward payoff looks like

Short forward


4848

Profit or Loss

0

XS

What if we short call ...


4949

Profit or Loss

0

XS

What if we short call and long put with identical strikesand expiration dates?


5050

Profit or Loss

0

XS



5151


Long Forward = { short call + long put }


5252

Profit or Loss

0

XS

Remember that short forward payoff looks like

Short forward


5353

Using options

5454

Trading strategies

5555

XST

Straddle

Trading strategies

5656

long put ...

long put

XST

Trading strategies

5757

long put and long call with the same strike price and expiration date.

long call

XST

Trading strategies

5858


long call long put

XST

Trading strategies

5959

long call long put

XST

Straddle


Trading strategies

6060

long call long put

XST

Straddle


Trading strategies

6161

long call long put

XST

Straddle


Trading strategies

6262

XST

Straddle


Trading strategies

6363

long call and put with the same strike price and expiration date.

Price Call Payoff Put Payoff Total Payoff

ST < X 0 X - ST X - ST

ST > X ST - X 0 ST - X

Trading strategies

6464

Trading strategies

6565

ST

Butterfly spread

Trading strategies

6666

Butterfly spread = long call with X1

X1 ST

Butterfly spread

long call

Trading strategies

6767

Butterfly spread = long call with X1 + short call with X2

X1 ST

X2

short call

Trading strategies

6868

Butterfly spread = long call with X1 + short call with X2 + long call with X3.

X1 ST

X2

X3long call

Trading strategies

6969


X1 ST

X2

X3

short call

long call

long call

Trading strategies

7070


X1 ST

X2

X3

short call

long call

long call

Trading strategies

7171


X1 ST

X2

X3

short call

long call

long call

Trading strategies

7272


X1 ST

X2

X3

short call

long call

long call

Trading strategies

7373


X1 ST

X2

X3

short call

long call

long call

Trading strategies

7474

Butterfly spread = long call with X1 + short 2 calls with X2 + long call with X3.

X1 ST

Butterfly spreadX2

X3

short call

long call

long call

Trading strategies

7575

Butterfly spread = long call with X1 + short 2 calls with X2 + long call with X3.

X1 ST

Butterfly spreadX2

X3

Trading strategies

7676

X1ST

X2

Strangle

Trading strategies

7777

Strangle = long put with X1

long put

X1ST

X2

Trading strategies

7878

Strangle = long put with X1 + long call with X2

long call

X1ST

X2

Trading strategies

7979

long call

X1ST

X2


long put

Trading strategies

8080

long call

X1ST

Strangle

X2


long put

Trading strategies

8181

long call

X1ST

Strangle

X2


long put

Trading strategies

8282

long call

X1ST

Strangle

X2


long put

Trading strategies

8383

long call

X1ST

Strangle

X2


long put

Trading strategies

8484

X1ST

Bull Spread

X2

Trading strategies

8585

Bull Spread = long call with X1

long call

X1ST

X2

Trading strategies

8686

Bull Spread = long call with X1 + short call with X2

short call

X1ST

X2

Trading strategies

8787


long call short call

X1ST

X2

Trading strategies

8888



X1ST

X2

Trading strategies

8989



X1ST

X2

Trading strategies

9090



X1ST

X2

Trading strategies

9191



X1ST

X2

Trading strategies

9292

X1ST

Bear Spread

X2

Trading strategies

9393

Bear Spread = short call with X1

short call

X1ST

X2

Trading strategies

9494

Bear Spread = short call with X1 + long call with X2

long call

X1ST

X2

Trading strategies

9595


long call

short call

X1ST

X2

Trading strategies

9696


long call

X1ST

X2

short call

Trading strategies

9797


long call

X1ST

X2

short call

Trading strategies

9898


long call

X1ST

X2

short call

Trading strategies

9999


long call

X1ST

X2

short call

Trading strategies

100100

American Put and Call

101101

American Put and Call

•First of all, American call is more expensive than European call and American put is more expensive than European put.

•C > c and P > p

•Why?

•American style options can be exercised at any time before the date of maturity…which means that they can be AT LEAST exercise the same day as European option is exercised.

•Having American option gives you more freedom.

•You have to pay for that!

102102

Exotic Options

•Bermudan Option - early exercise is restricted to certain dates during the life of option.

•Forward Start Option - options that are paid for now but will start at some time in the future. Employee incentive scheme.

•Compound Options - Options on Options.

103103

Exotic Options

•“As You Like It” Option - the holder can choose if option is call or put.

•Barrier Option - the payoff depends on whether the exchange rate reaches a certain level during a certain period of time.

•Cash-or-Nothing Option - pays off nothing is the stock price ends up above the strike price and pays off cash if it ends up above the strike price.

104104

Exotic Options

105105

Policy matters

As with any derivatives market, a generic question is whether the existence of the option market leads to negative spillover effects, such as an increase in the volatility of the underlying asset.

A related public policy concern is the risk to which option traders are exposed and how the capital requirements for those risks should be measured.

Documents

HEDGING FOREIGN CURRENCY RISK: OPTIONS