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International Finance
FINA 5331
Lecture 14:
Hedging currency risk with currency
options
Aaron Smallwood Ph.D.
Currency options
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•
•
•
An options contract can be bought/sold not only over the
counter, but also on a centralized exchange. In the case of an
options contract, there are several centralized exchanges
including the Philadelphia Stock Exchange.
–
Options contracts bought and sold on exchanges are only
available in certain currencies. In particular, an options
contract is available for Australian dollars, British pounds,
Canadian dollars, euros, Japanese yen, and Swiss franc (all
against the $) on the Philadelphia Stock Exchange.
–
Options contracts bought and sold on exchanges are only sold
in fixed lots. In particular, on the Philadelphia Stock
Exchange, currency options are available in the following
denominations:
A$ 10,000
£10,000
C$ 10,000
€10,000
¥ 1,000,000
CHF 10,000
Currency options…continued
– Currency options sold on a centralized exchange have specific
delivery dates. In particular, a currency option bought or sold on
the Philadelphia Stock Exchange matures on the Friday before
the third Wednesday of the expiration month. Contracts on the
exchange have a trading cycle of March, June, September, and
December with two additional near term monthly contracts. This
implies that if it is November, then there will be options contracts
available in the next two months (December and January).
– Unlike a forward contract, the culmination of the contract need
not result in delivery of currency. For example, if an options
contract is purchased in Canadian $, the trader never has to take
delivery of Canadian $ as a result of the contract if they don’t
wish to. In other words, the trader has the right, but not the
obligation to take delivery of currency in the future. The trader
will only use the option if the movements in future exchange
rates make it profitable or cost-efficient to do so.
– Today, the Philadelphia stock exchange offers pure dollar settled
contracts.
Speculating with put options
• Consider a trader that wishes to short yen. They
can use a put option. Suppose they have
access to an August put with a strike price of
100.00 (all contracts are listed as cents per unit
of foreign currency…except ¥, which is listed as
cents per 100 units of foreign currency). Trader
wishes to sell ¥10,000,000 (e.g. 10 contracts).
• This is a risky strategy (implies a depreciation of
the yen relative to the current exchange rate).
Suppose when the contract matures,
S($/¥)=$0.0092. Trader WINS…How?
Profit
• With put option, we exercise when future
exchange rate is LESS than strike price.
– We sell ¥10,000,000 at $0.01.
– Problem, where do we get yen?
• Buy them in the spot market at $0.0092.
• We still have to pay the premium. Suppose the
premium is $0.000255
– Total profit:
– (0.01-0.0092-.000255)* ¥10,000,000=
$5,450.
Illustration
Profit
$9,745
Q - What is the maximum gain for one put option?
A - $9,745 = ¥1,000,000×($0.01 – $0.000255)
or
$10,000 - $255 = $9,745.00
Q - At what exchange rate do you break even?
A - $0.01-$0.000255=$0.009745
–$255.00
$0.00974
5
0.01
loss
Future
Spot
Rate
Hedging with call options
• Consider a US importer that buys goods from
Germany for delivery in three months. The US
trader owes €1,000,000 at the time of delivery.
• The trader cares about the cost in US dollars.
The trader is concerned that the euro will
appreciate in value. The trader could purchase
a call option.
• Suppose the trader selects the call option with a
strike price of 129.
Scenario #1
• Suppose on August 17, the dollar price of the
euro ends up being $1.23.
• The options expires “out of the money.” The
trader will not exercise the option.
• The trader must pay the premium:
– .0094*1,000,000=9,400
– Total cost of purchasing euros:
$1,230,000+9,400=$1,239,400.
– For any exchange rate less than or equal to 1.29, the
trader will lose because they have to pay the full
premium amount.
Scenario #2
• Suppose the dollar price of the euro ends up
being $1.40. The trader is much better off with
the option.
• The option is exercised. The trader would prefer
to buy at $1.29
• They will still the pay the premium amount.
– With an option the trader will pay $1,290,000
+$9,400=$1,299,400.
– Without an option, the trader would have paid
$1,400,000.
– The option saved the trader $1,400,000$1,299,400=100,600
Scenario 3
• Suppose the exchange rate ends up being
$1.2955. The trader exercises the option.
• In spite of using the option, the trader would
have actually been better without one.
• With the option, the trader would prefer to buy
euros at $1.29.
• They lose the premium amount no matter what.
• The total cost anytime the trader exercises the
option is $1,299,400.
• In this case, without the option, the trader would
only have paid $1,295,500.
Graphical illustration