©1998-20031 foreign currency options ii. ©1998-2003 1. using options for hedging
TRANSCRIPT
©1998-2003
The set up (Using calls)
• A U.S. importer must pay CHF250,000
• The payment will occur in late September
• The importer is concerned that CHF may appreciate against the dollar so that its dollar-denominated payment may increase.
©1998-2003
What to do today?
• On July 16 the importer can buy 4 PHLX calls on the Swiss francs (CHF62,500 per contract),
• Pay $2,625 for 4 contracts (1.05 cents per CHF)
• The strike price X of a call is $/CHF0.58 and its expiration date is in September
CHF62,5004CHF250,000
F$0.0105/CH250,000$2,625/CHF
©1998-2003
Expiration: scenario 1
• The spot price of CHF at expiration is $0.5790• Since S < X, Max{(S - X), 0} = 0, the intrinsic
(and total) value is 0• The option will not be exercised, i.e. it expires
worthless• The importer incurs a total loss (or more
precisely a hedging cost) of $2,625 which was paid initially for 4 call options
• The profit for the underwriter (the counterparty of the option contract) is $2,625
©1998-2003
Expiration: scenario 2
• The spot price of CHF at expiration is $0.5820• Since S > X, Max{(S - X), 0} = $0.0020, the
intrinsic value is 0.20 cents per Swiss franc• The U.S. importer exercises the option and gets
• The importer incurs a total net loss (hedging cost) of $2,125:
• The underwriter’s profit is $2,125
CHF250,000$0.0020CHF$500
$500$2,620$2,125
©1998-2003
Expiration: scenario 3
• The spot price of CHF at expiration is $0.5920• Since S > X, Max{(S - X), 0} = $0.0120, the
intrinsic value is 1.20 cents per Swiss franc• The U.S. importer exercises the option and gets
• The importer has a total net gain of $375:
• The underwriter’s loss is $375
CHF250,000F0.0120$/CH$3,000
$2,625$3,000$375
©1998-2003
Call option on a diagram
$/CHF spot rate
0.58
Option profitcents/CHF
Long call
Short call
Strike price
Profit
Loss
Limited loss
Limited Profit0
“At the money”
©1998-2003
The Set up (Using puts)
• An American exporter will receive CHF250,000
• The receipt will occur in late September
• The exporter is concerned that CHF may depreciate against the dollar so that its dollar-denominated cash inflow may be reduced.
©1998-2003
What to do today?
• On July 16 the exporter can buy 4 PHLX puts on the Swiss Frank (CHF62,500 per contract),
• Pay $2,225 for 4 contracts (0.89 cents per CHF)
• The strike price of a put is $0.58 and its expiration date is in September
62,5004CHF250,000
$0.0089250,000$2,225/CHF
©1998-2003
Expiration: scenario 1
• The spot price of CHF at expiration is $0.5810• Since S > X, Max{(X - S), 0} = 0, the intrinsic
(and total) value is 0• The option will not be exercised
• The exporter incurs a total loss of $2,225 which was paid initially for 4 put options
• The underwriter’s profit is $2,225
©1998-2003
Expiration: scenario 2
• The spot price of CHF at expiration is $0.5780• Since S < X, Max{(X - S), 0} = $0.0020, the
intrinsic value is 0.20 cents per Swiss franc.• The U.S. exporter exercises the option and gets
• The exporter incurs a total net loss of $1,725:
• The underwriter’s profit is $1,725
CHF250,000F0.0020$/CH$500
$500$2,225$1,725
©1998-2003
Expiration: scenario 3
• The spot price of CHF at expiration is $0.5680• Since S < X, Max{(S - X), 0} = $0.0120, the
intrinsic value is 1.20 cents per Swiss franc• The U.S. exporter exercises the option and gets
• The exporter has a total net gain of $775:
• The underwriter’s loss is $775
CHF250,000F0.0120$/CH$3,000
$2,225$3,000$775
©1998-2003
Put option on a diagram
$/CHF spot rate
0.58
Option profitcents/CHF
Long put
Short put
Strike price
Limited loss
Limited Profit
Profit
Loss
“At the money”
©1998-2003
Alternative strategies: Forwards and futures
• Forwards and futures offer a protection against exchange rate risk exposure at the lowest cost.
• Options offer a protection at a premium.
• Forwards and futures eliminate any upside (positive) impact of the exchange rate risk.
• Options do not eliminate the upside (positive) impact of the exchange rate risk.
©1998-2003
The set up(Using options or futures)
• On July 1, an American company makes a sale for which is will receive CHF125,000 on September 1.
• The spot price of CHF is $0.6922.• The firm wants to protect itself against a
declining Swiss franc by selling its expected CHF receipts forward (using a futures contract) or by buying (long) a CHF put option.
©1998-2003
The menu of strategies
• Do nothing and take the risk of declining value of the Swiss Franc mark against U.S. dollar
• Sell a September futures contract
• Buy a put option
©1998-2003
Scenario 1: depreciating CHF
July 1 September 1
Spot $0.6922 $0.6542
September futures $0.6956 $0.6558
September 68 long put $0.0059 $0.0250
September 70 long put $0.0144 $0.0447
©1998-2003
Scenario 1: Strategies 1 & 2
• With do nothing strategy, the company will incur a loss of $4,750
• With selling short a futures contract, the company will– loose $4,750 in the spot market– gain $4,975 in the futures market
– net profit $225
CHF125,000HF0.6542)$/C(0.6922$4,750
CHF125,000HF0.6558)$/C(0.6956$4,975
©1998-2003
Scenario 1: Strategy 3.1
• With buying September 68 put options, the company will – loose $4,750 in the spot market – gain $2,387.50 in the option market
(exercising the put)
– incur a net loss of $2,362.50
CHF125,0000.0059)CHF$(0.0250$2,387.50
©1998-2003
Scenario 1: Strategy 3.2
• With buying September 70 put options, the company will gain– loose $4,750 in the spot market – gain $3,787.50 in the option market (selling
put)
– Incur a net loss of $962.50
CHF125,0000.0144)CHF$(0.0447$3,787.50
©1998-2003
Scenario 2: appreciating CHF
July 1 September 1
Spot $0.6922 $0.7338
September futures $0.6956 $0.7374
September 68 put $0.0059 $0.0001
September 70 put $0.0144 $0.0001
©1998-2003
Scenario 2: Strategies 1 & 2
• With do nothing strategy, the company will have a gain of $5,200
• With selling short a futures contract, the company will– gain $5,200 in the spot market– loose $5,225 in the futures market
– net loss $25
CHF125,000HF0.6922)$/C(0.7338$5200
CHF125,000HF0.6956)$/C(0.7374$5,225
©1998-2003
Scenario 2: Strategy 3.1
• With buying September 68 put options, the company will– gain $5,200 in the spot market – loose $725 in the option market (selling put)
– net gain $4,475
CHF125,0000.0001)CHF$(0.0059$725
©1998-2003
Scenario 2: Strategy 3.2
• With buying September 70 put options, the company will – gain $5,200 in the spot market – loose $1,787.50 in the option market (selling
put)
– net gain of $3412.50
CHF125,0000.0001)CHF$(0.0144$1,787.50
©1998-2003
The summary table
Position CHF depreciates CHF appreciates
Unhedged $4,750 loss $5,200 gain
Short futures $225 gain $25 loss
Long 68 put $2,050 loss $4,475 gain
Long 70 put $800 loss $3,412.50 gain
©1998-2003
Concluding remarks
• There is no absolute best hedging strategy• The choice of a specific hedge strategy is
dictated by many factors, including:amount of foreign currency needed to be hedged– availability of funds for paying the option’s premium– characteristics and availability of derivatives contracts– a company’s expectations about future exchange rate
changes– hedging habit & corporate culture