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Understanding Forwards & Options

This document provides information on forward contracts, interest rate parity principle, and options. It defines forward contracts as agreements to buy or sell a currency at a predetermined future date. Interest rate parity principle states that the difference between the spot and forward rates is determined by interest rate differentials. Options give the buyer the right but not obligation to buy or sell currency at a strike price by expiry. The document discusses option types, premium determinants, and zero-cost option strategies like range forwards and reverse ranges.

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220 views39 pages

Understanding Forwards & Options

This document provides information on forward contracts, interest rate parity principle, and options. It defines forward contracts as agreements to buy or sell a currency at a predetermined future date. Interest rate parity principle states that the difference between the spot and forward rates is determined by interest rate differentials. Options give the buyer the right but not obligation to buy or sell currency at a strike price by expiry. The document discusses option types, premium determinants, and zero-cost option strategies like range forwards and reverse ranges.

Uploaded by

Sameer
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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UNDERSTANDING

FORWARDS &
OPTIONS

Forward Contracts
Contract to sell or buy a currency at a rate agreed
today; for delivery at a pre-determined future date or
time period
Difference between the spot and the forward rate is
called, forward points, swap points, or forward
margin.
Outright forward rate = spot rate + forward points

Interest Parity Principle


Between two freely convertible currencies, the difference
between the spot rate and the forward rate is determined by
the interest rate differential between the two currencies.
Spot
: 1 Euro = 1.3335 USD
6 month Interest Rates : USD 1.72 % ; EUR 1.66%
6m Forward 1 Euro = 1. 3339 USD
=

Spot Rate * Interest Rate Differential * Forward Period


100 * No. of days in the year (or) Months in a Year
= 1.3335*(1.72-1.66)*6 / 100*12
= 0.0004

Interest Parity Principle....


To Verify
Borrow 1 EUR at 1.65%
Sell 1 EUR against 1.3335 USD Spot
Invest 1.3335 USD at 1.72%

Int. payable 0.0083


Int. receivable 0.01146

To eliminate arbitrage todays 6m forward should be such that


USD 1.34496 = Euro 1.0083
1 Euro = (1.34496/1.0083) = USD 1.3339

Interest Parity Principle.


Currency with low interest rate will be at a premium
Currency with high interest rate will be at a discount
Forward rate is no indication of future spot rate

Calculation of Annualised Premiums


Spot $/Re
= Rs. 50.35
6M - Fwd.Premium = Rs 0.68
Annualized Premium

: Premium * 100 * 365


Spot
*
n
n = Premium period in days
0.68 * 100 * 365
50.35
*
180
Result : 2.73%

Fixed Date Forward Calculations


USD/INR
Spot Rate
30 Apr

50.3
50.10

50.37
0.12

31 May
30 Jun

0.24
0.34

0.26

31 Jul

0.41

0.43

0.36

USD Exports for 15/07/09


USD/INR = 50.35 +0.3738 = 50.72

$/Re premium up to 30/06 (.34) + premium for 15 days in Jul 09


= 0.3400+(0.41-0.34) * 15/31= (0.3738)

Option Forwards (Time Options)


Spot Rate

50.35

50.37

30 April

0.10

0.12

31 May

0.24

0.26

30 June

0.34
0.41

0.36

31 July

0.43

USD Imports for July 2nd half


USD/INR = 50.37 + 0.4300 + Banks Margin
Premium charged up to 31/07/09
USD Exports for July 2nd half (they will get only till 15 th Jul)
USD/INR = 50.35 - 0.3738 - Banks Margin
Premium provided up to 15/05/09 = 0.3400 + (0.4100-0.3400)* 15/31
(BANK IS THE WINNER IN BOTH THE CASES)

Cancellation
On 1st Feb-09, an exporter sold $100000 for 30th Jun 09
delivery @ 50.25
I Contract cancelled 2 months before maturity
On 30/04, with the 2 month forward rate from cancellation date
to 30th Jun at say 51.00 the cancellation loss of Rs.(75000) i.e
(51.00-50.25)*100,000) will be recovered from the customer.
II Automatic cancellation on the 7th day from the
date of maturity If a gain is made on cancellation, the gain
will not be passed on to the customer but the loss will of course
be recovered.

Exchange Control aspects


Facility of forward cover available to by a person, company, firm
etc, limited facilities available to FIIs, NRIs and OCBs
Existence of a genuine underlying exposure
Documentary support but now relaxed without documents
forward contracts can be booked to the extent of 100% of Avg
export/import turnover for past 3 years.
Choice of currency & tenor left to customer
maturity of cover should not exceed maturity of transaction
Export contracts can be booked, cancelled, rolled over

Exchange Control aspects


The customer can be given the facility of booking a single
forward contract for several orders provided that the receivables are
in the same currency and the likely cash flow period falls within the
same contract period.
Exporters are allowed to deliver exchange representing a portion
of the export value in part utilisation of the forward contract.

Managing
Risk
Using Option

Option
A contract where the buyer has the right, but not the
obligation to
- Buy/Sell
- Specified quantity of a currency
- At a specified price (strike price)
- By a particular date (expiry date)
For this right, the buyer pays the seller(writer) of the
option an upfront fee (called option premium)

Option

v/s

Option give the buyer a


right but no obligation.
Good
instrument
to
hedge adverse price
moves
&
avoiding
opportunity loss.
Upfront premium
Can choose the strike
price
Specific date

Forward

Forwards are fixed price


contracts wherein the
buyer/seller is obligated
to the price
Opportunity loss
No upfront premium
Cannot
choose
the
strike price
Option forwards (time
options)

Two types of option


American Option
May be exercised at any time during the life of a contract.
European Option.
May be exercised only at maturity or expiry date.

Option Terminologies
Call Option
Gives the holder the right but not the obligation to
BUY an underlying at a fixed price from the writer of
the option.
Put Option
Gives the holder the right but not the obligation to
SELL an underlying at a fixed price to the writer of
the option

Option - Example
USD Exports - due 31st August 2009
Company buys an USD put option with a strike price of
50.00 when spot rate is 49.76
2 business days before the expiry date, the company has to
decide whether or not exercise the option.
So on 29th August at the specified cut-off time, if spot USD is
say 48.80, the company will exercise the option and sell
USD at 50.00
However, if spot rate is say 51 then the company can let the
option lapse and instead fix the spot rate for the transaction
on 29th August.

Risk / Profit Profile


Buyer

Seller

Profit

Unlimited

Premium

Risk

Premium

Unlimited

Option Specs,
Strike Price or Exercise price
The fixed price at which the option holder has the
right to buy or sell the underlying currency.
Expiry Date
The last day on which the option may be exercised.
Life or Exercise Period
The period of time during which the option holder
enjoys the purchased option contracts.

Option strike price


In the money (ITM)
The option is In the Money when the Strike Price is favourable
to the option holder(buyer) than the current forward rate.
Eg: USD put option with strike 50.00 current fwd rate 49.20
option in the money
Out of the money (OTM)
The option is Out of the Money when the Strike Price is
unfavourable to the option holder(/buyer) than the current
forward rate.
Eg: USD put option with strike 45.00 current fwd rate 49.20
option out of the money
At the money (ATM)
The option is At the Money when the Strike Price is equal to
the current forward rate.

Price of an Option
Can the Option buyer have the cake & eat it too?
Not really - since the option seller charges the buyer an
upfront premium payable in cash.
And the upfront premium can be as high as 1% or even more
depending on the strike price and the maturity period.

Option Premium
Intrinsic Value
The difference between the strike price and the current
market price, when the option is in the money.

Time Value
Value based on possibility of favourable price movements
before expiry.

TIME VALUE + INTRINSIC VALUE = PREMIUM

The Premium of a Put Option divided into Time


Value & Intrinsic Value
0.9000

Spot USD/INR : 46.05


0.8000

Premium

Fwd USD/INR: 46.55

0.7000

Intrinsic Value

0.6000

Time value

0.5000
0.4000
0.3000
0.2000
0.1000
0.0000

46.05

46.15

46.25

46.35

46.45

46.55

46.65

46.75

46.85

46.95

As the strike of the put (x-axis) increases, the premium goes up. For an out of money put,
there is only time Value and no intrinsic value. As soon as the strike goes above the forward
rate (i.e. option becomes ITM), time value starts to come down and intrinsic value goes up.

47.05

47.15

Option premium - Quotations


Points of the second currency/terms currency
or
Premiums are quoted as a flat percentage of the base currency
principal amount

Factors determining Premium value


Volatility
Strike Price
Life or Exercise Period
Interest Rates - domestic & foreign
Current Market Rate

Change in premium with change in volatility


0.025

0.02

0.015

0.01
X axis - Volatility in %
Y axis - Option Premium

0.005

0
1

10

Strike Price Dynamics


The option premium can be quite high for ATM options.
Is there a way to reduce the premium ?
There is one golden rule. You cant get anything in the
market for free.
So to reduce the premium, you have to give up some
protection.
To reduce the premium, you have to raise the strike price
and consider buying an OTM option thereby giving up
some protection. The more OTM the option is, the lower
will be the premium. Conversely, the more ITM an option
is, the higher will be the premium.

Option Strategies

PLAIN VANILLA OPTION

Exporter Buy a USD Put/ INR Call at 51.03


Cost Rs. 1.70 per $
Maturity 30th September 2009
Spot 50.30 Forward Rate 51.03

Explanation : On maturity
if USD/INR < 51.03 , corporate sells USD at 51.03
if USD/INR > 51.03 , Corporate sells at spot
The maximum loss in this structure is the cost paid for the
option and is known upfront and the gains are unlimited!!

ZERO COST OPTION STRATEGIES


An option buyer can reduce his premium cost by selling
another option. The combination can reduce the cost as
the premium received on the option sold could either
partially or fully offset the cost of option bought.
Different Strategies:
1. Range Forward
2. Reverse Range
3. Participating Forward
4. Leveraged
5. Leveraged

RANGE FORWARD

Definition : Buy a USD put / INR Call at 49.40


Sell a USD Call/INR Put at 52.00
Maturity : 30th September 2009

Explanation : On maturity
if USD/INR < 49.40 , corporate sells USD at 49.40
if USD/INR > 52.00 , Corporate forced to sell at 52.00
If USD/INR is between 49.40 and 52.00, then the corporate
gets the spot.

REVERSE RANGE

Definition : Buy a USD put / INR Call at 52.00


Sell a USD Call/INR Put at 49.50
Maturity : 30th September 2009

Explanation : On maturity
if USD/INR < 49.50, corporate sells USD at 52.00
if USD/INR > 52.00 , Corporate forced to sell at 49.50
If USD/INR is between 49.50 and 52.00, then the corporate
sells at {49.50+(52.00-Spot on maturity)}.

PARTICIPATING FORWARD

Definition : Buy a USD put / INR Call at 49.50


Sell a 0.5 USD Call/INR Put at 49.50
Maturity : 30th September 2009

Explanation : On maturity
if USD/INR < 49.50 , corporate sells USD at 49.50
if USD/INR > 49.50 , Corporate forced to sell half of the
exposure at 49.50 and the balance at the spot.

LEVERAGED
Definition : Buy a USD put / INR Call at 51.75
Sell a 2 USD Call/INR Put at 51.75
Maturity : 30th September 2009

Explanation : On maturity
if USD/INR < 51.75 , corporate sells USD at 51.75
if USD/INR > 51.75 , Corporate forced to sell twice the
amount at 51.75

Rupee Option Product specs


Vanilla European options & combinations thereof at
introduction. This will continue till banks have
sophisticated systems & risk management frameworks to
hedge this new non-linear product.
Over the counter contracts.
Can be tailored to suit the corporates need.
No minimum optional amt recommended by RBI.
Premium payable on spot basis.

Rupee Option Product specs..,


Settlement would be either by delivery on spot basis or
net cash settlement in Rupees on Spot basis, depending
on the FC-INR spot rate on maturity date. (specs will be
specified in the contract) RBI reference rate could be the
reference rate for settlement.
Strike Price & Maturity could be tailored to suit
counterparties needs typical maturities are 1 week,
2weeks, 1, 2, 3, 6, 9 & 12 months.
Exercise style: European.

Uses of Rupee option


To hedge genuine FX exposures arising out of
trade/business (Banks may book transactions based on
estimated exposure for uncertain amounts)
To hedge FC loans.
Balance in EEFC accounts.

One hedge for one exposure


Only one hedge may be booked against a particular
exposure for a given time period.
For eg Exporter with USD receivables after 6 months,
can sell a forward for 3 month & after 3 month square the
forward & book an option for another 3 months.
But the exporter/importer cannot book a forward & an
option for the same exposure at the same time.

Thank You

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