hedging foreign currency risk: options
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HEDGING FOREIGN CURRENCY RISK: OPTIONS
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…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.
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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.
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Why options?
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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.
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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 $0.65 per
SFr on (and only on) Mar 15, 2002. This “put on SFr” is also a “call on US$”.
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Contract specifications
The buyer of this call option would expect to pay 62,500 $0.0189 = $1,181.25 plus commission charges.
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European Call and Put
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European Call and Put
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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$
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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$
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European Call and Put
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Long foreign currency callProfit or Loss
0
1515
X
S
Strike Price
Profit or Loss
0
Long foreign currency call
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X
S
Value of exchange rateat expiration day
Profit or Loss
0
Long foreign currency call
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X
SRisk of Loss
ST < X
Profit or Loss
0
Long foreign currency call
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X
S
Possible Profit
ST > X
Profit or Loss
0
Long foreign currency call
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0
X
SRisk of Loss
Possible Profit
ST < X ST > X
Profit or Loss
Long foreign currency call
2020
European Call and Put
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Long foreign currency put
0
X
S
Profit or Loss
2222
0
X
S
Possible Profit
ST < X
Profit or Loss
Long foreign currency put
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0
X
SRisk of Loss
ST > X
Profit or Loss
Long foreign currency put
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0
X
SRisk of Loss
Possible Profit
ST < X ST > X
Profit or Loss
Long foreign currency put
2525
Short foreign currency call
0
XS
Profit or Loss
2626
0
XS
Risk of Loss
Possible Profit
ST < X
Profit or Loss
Short foreign currency call
2727
0
XS
Risk of Loss
ST > X
Profit or Loss
Short foreign currency call
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0
XS
Risk of Loss
Possible Profit
ST < X ST > X
Profit or Loss
Short foreign currency call
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Short foreign currency put
0
XS
Profit or Loss
3030
Profit or Loss
0
XS
Risk of Loss
ST < X
Short foreign currency put
3131
Profit or Loss
0
XS
Possible Profit
ST > X
Short foreign currency put
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Profit or Loss
0
XS
Risk of Loss
Possible Profit
ST < X
ST > X
Short foreign currency put
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•Option which would generate profit if exercised immediately is said to be in the money.
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•In the money: St>X for Calls and St<X for Puts.
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•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.
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•In the money: St>X for Calls and St<X for Puts.
•At the money: St=X for Calls and St=X for Puts.
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•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.
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•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.
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How does it compare to Forwards?
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Profit or Loss
XS
Remember that long forward payoff looks like
Long forward
How does it compare to Forwards?
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Profit or Loss
0
XS
What if we long call...
How does it compare to Forwards?
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Profit or Loss
0
XS
What if we long call...
Long call
How does it compare to Forwards?
4343
Profit or Loss
0
XS
What if we long call and short put with identical strikesand expiration dates?
Short put
How does it compare to Forwards?
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Profit or Loss
0
XS
What if we long call and short put with identical strikesand expiration dates?
Long call
Short put
How does it compare to Forwards?
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What if we long call and short put with identical strikesand expiration dates?
Long Forward = { long call + short put }
How does it compare to Forwards?
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Profit or Loss
XS
Remember that long forward payoff looks like
Long forward
0
How does it compare to Forwards?
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Profit or Loss
0
XS
Remember that short forward payoff looks like
Short forward
How does it compare to Forwards?
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Profit or Loss
0
XS
What if we short call ...
How does it compare to Forwards?
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Profit or Loss
0
XS
What if we short call and long put with identical strikesand expiration dates?
How does it compare to Forwards?
5050
Profit or Loss
0
XS
What if we short call and long put with identical strikesand expiration dates?
How does it compare to Forwards?
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What if we short call and long put with identical strikesand expiration dates?
Long Forward = { short call + long put }
How does it compare to Forwards?
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Profit or Loss
0
XS
Remember that short forward payoff looks like
Short forward
How does it compare to Forwards?
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Using options
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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 put and long call with the same strike price and expiration date.
long call long put
XST
Trading strategies
5959
long call long put
XST
Straddle
long put and long call with the same strike price and expiration date.
Trading strategies
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long call long put
XST
Straddle
long put and long call with the same strike price and expiration date.
Trading strategies
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long call long put
XST
Straddle
long put and long call with the same strike price and expiration date.
Trading strategies
6262
XST
Straddle
long put and long call with the same strike price and expiration date.
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
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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
Butterfly spread = long call with X1 + short call with X2 + long call with X3.
X1 ST
X2
X3
short call
long call
long call
Trading strategies
7070
Butterfly spread = long call with X1 + short call with X2 + long call with X3.
X1 ST
X2
X3
short call
long call
long call
Trading strategies
7171
Butterfly spread = long call with X1 + short call with X2 + long call with X3.
X1 ST
X2
X3
short call
long call
long call
Trading strategies
7272
Butterfly spread = long call with X1 + short call with X2 + long call with X3.
X1 ST
X2
X3
short call
long call
long call
Trading strategies
7373
Butterfly spread = long call with X1 + short call with X2 + long call with X3.
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
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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
Strangle = long put with X1 + long call with X2
long put
Trading strategies
8080
long call
X1ST
Strangle
X2
Strangle = long put with X1 + long call with X2
long put
Trading strategies
8181
long call
X1ST
Strangle
X2
Strangle = long put with X1 + long call with X2
long put
Trading strategies
8282
long call
X1ST
Strangle
X2
Strangle = long put with X1 + long call with X2
long put
Trading strategies
8383
long call
X1ST
Strangle
X2
Strangle = long put with X1 + long call with 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
Bull Spread = long call with X1 + short call with X2
long call short call
X1ST
X2
Trading strategies
8888
Bull Spread = long call with X1 + short call with X2
long call short call
X1ST
X2
Trading strategies
8989
Bull Spread = long call with X1 + short call with X2
long call short call
X1ST
X2
Trading strategies
9090
Bull Spread = long call with X1 + short call with X2
long call short call
X1ST
X2
Trading strategies
9191
Bull Spread = long call with X1 + short call with X2
long call short call
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
Bear Spread = short call with X1 + long call with X2
long call
short call
X1ST
X2
Trading strategies
9696
Bear Spread = short call with X1 + long call with X2
long call
X1ST
X2
short call
Trading strategies
9797
Bear Spread = short call with X1 + long call with X2
long call
X1ST
X2
short call
Trading strategies
9898
Bear Spread = short call with X1 + long call with X2
long call
X1ST
X2
short call
Trading strategies
9999
Bear Spread = short call with X1 + long call with X2
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.
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