Download Foreign Currency Options II

Foreign Currency
Options II
©1998-2003
1
1. Using Options for Hedging
©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 dollardenominated 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),
CHF250,000  4  CHF62,500
• Pay $2,625 for 4 contracts (1.05 cents per CHF)
$2,625/CHF 250,000  $0.0105/CHF
• The strike price X of a call is $/CHF0.58 and its
expiration date is in September
©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
$500  $0.0020CHF  CHF250,000
• The importer incurs a total net loss (hedging
cost) of $2,125:
$2,125  $2,620  $500
• The underwriter’s profit is $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
$3,000  0.0120$/CHF  CHF250,000
• The importer has a total net gain of $375:
$375  $3,000  $2,625
• The underwriter’s loss is $375
©1998-2003
Call option on a diagram
Option
profit
cents/CHF
Strike price
Long call
Profit
0
Limited Profit
$/CHF spot rate
Limited loss
Loss
0.58
“At the money”
©1998-2003
Short call
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 dollardenominated 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),
CHF250,000  4  62,500
• Pay $2,225 for 4 contracts (0.89 cents per CHF)
$2,225/CHF 250,000  $0.0089
• The strike price of a put is $0.58 and its
expiration date is in September
©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
$500  0.0020$/CHF  CHF250,000
• The exporter incurs a total net loss of $1,725:
$1,725  $2,225  $500
• The underwriter’s profit is $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
$3,000  0.0120$/CHF  CHF250,000
• The exporter has a total net gain of $775:
$775  $3,000  $2,225
• The underwriter’s loss is $775
©1998-2003
Put option on a diagram
Option
profit
cents/CHF
Strike price
Short put
Profit
Limited Profit
Limited loss
Loss
Long put
0.58
“At the money”
©1998-2003
$/CHF spot rate
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
Spot
September futures
September 68 long put
September 70 long put
$0.6922
$0.6956
$0.0059
$0.0144
©1998-2003
September 1
$0.6542
$0.6558
$0.0250
$0.0447
Scenario 1: Strategies 1 & 2
• With do nothing strategy, the company will incur
a loss of $4,750
$4,750  (0.6922  0.6542)$/C HF  CHF125,000
• With selling short a futures contract, the
company will
– loose $4,750 in the spot market
– gain $4,975 in the futures market
$4,975  (0.6956  0.6558)$/C HF  CHF125,000
– net profit $225
©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)
$2,387.50  $(0.0250  0.0059)CHF  CHF125,000
– incur a net loss of $2,362.50
©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)
$3,787.50  $(0.0447  0.0144)CHF  CHF125,000
– Incur a net loss of $962.50
©1998-2003
Scenario 2: appreciating CHF
July 1
Spot
September futures
September 68 put
September 70 put
$0.6922
$0.6956
$0.0059
$0.0144
©1998-2003
September 1
$0.7338
$0.7374
$0.0001
$0.0001
Scenario 2: Strategies 1 & 2
• With do nothing strategy, the company will have
a gain of $5,200
$5200  (0.7338  0.6922)$/C HF  CHF125,000
• With selling short a futures contract, the
company will
– gain $5,200 in the spot market
– loose $5,225 in the futures market
$5,225  (0.7374  0.6956)$/C HF  CHF125,000
– net loss $25
©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)
$725  $(0.0059  0.0001)CHF  CHF125,000
– net gain $4,475
©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)
$1,787.50  $(0.0144  0.0001)CHF  CHF125,000
– net gain of $3412.50
©1998-2003
The summary table
Position
Unhedged
Short futures
Long 68 put
Long 70 put
CHF depreciates
CHF appreciates
$4,750 loss
$225 gain
$2,050 loss
$800 loss
$5,200 gain
$25 loss
$4,475 gain
$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
©1998-2003