Hedging with Foreign Currency
Options
By Soeren Hansen
What is an Option?
A Currency Option is an option, but not an obligation to
buy or sell currency during a specified time period (time
to maturity, T) at a specified price (exercise/strike price,
X)
The price or value of the option is called the premium, P
Two different Options:
1. Call Option
2. Put Option
What is a Call -and a Put Option?
A currency Call option is an option but not
an obligation to buy currency during a
specified time period at a specified price
A currency Put option is an option but not
an obligation to sell currency during a
specified time period at a specified price
What is an European -and an American Option?
An European currency option is an option,
which can be exercised only on the
maturity date
An American currency option is an option
which can be exercised any time prior to
the maturity date
Why an Option?
Since the the holder of a Currency Option
has the right but not the obligation to trade
currency, it is beneficial to use options to
hedge potential transactions (ex. bids not
yet accepted)
The exercise/strike price and the premium
together determine the the floor or ceiling
established for the potential transaction
Call Option
The Call Option establishes a ceiling for the exchange rate, and
the option can be used to hedge foreign currency outflows
(potential payments)
If S>X
=> Profit increases one-for-one with appreciation of the foreign
currency. At (X+P) the holder of the option breaks even (ceiling
price)
If S<X
=> The call option will not be exercised, because the holder is
better off buying the foreign currency in the spot market. The
holder will have a negative profit reflecting the premium, P
Profit Profile for a Call Option
Profit
S
X X+P
-P
Put Option
The Put Option establishes a floor for the exchange rate, and the
option can be used to hedge foreign currency inflows
If S>X
=> The call option will not be exercised, because the holder is
better off selling the foreign currency in the spot market. The
holder will have a negative profit reflecting the premium, P
If S<X
=> Profit increases one-for-one with depreciation of the foreign
currency. At (X-P) the holder of the option breaks even (floor
price)
Profit Profile for a Put Option
Profit
S
X-P X
-P
Option Pricing
For European options
– Black-Scholes’ pricing model
– Garman & Kohlhagen
For both European and American option:
– Binomial pricing model
– Implicit finite difference method
I will not go into these different pricing models, but for the
interested student see John C. Hull ”Options, Futures and other
derivatives”
Principles of pricing currency options
The value of an option on its maturity date is
either its immediate exercise value or zero,
whichever is higher
If two options are identical in all respects with the
exception of the exercise price, a call option with a
higher exercise price will always have a lower
value and a put option with a higher exercise price
will always have a greater value than the
corresponding options with lower exercise prices
Principles of pricing currency options
If two American options are identical in all
respects with exception of the length of the
contract, the longer contract will have a greater
value at all times (more flexible)
Prior to expiration, an American option has a
value at least as large as the corresponding
European option (more flexible)
Principles of pricing currency options
A larger (positive) difference between the
domestic and foreign interest rate (i – i*),
increases the price of a call and decreases the price
of a put (expected appreciation of the home
currency)
The value of the option increases as the volatility
of the underlying currency increases
Example
B.Lack & S.Choles Enterprises of Salem, OR imports
French wine. The wine is really rare, so B.Lack & S.Choles
have to bid for the wine. On November 2nd B.Lack &
S.Choles bids €62,500, but the firm will not know until
December 15th whether the bid is accepted or not. Recently
the dollar tanked against the euro, so to protect against a
further appreciation of the euro, the firm purchases a
€62,500 call option. The strike price is 1.2750 $/€ and the
option premium is one cent pr. euro. The ceiling price is
therefore 1.2850 $/€, for a maximum payment of $80,312.5
Example
If the euro appreciates to 1.3000 $/€, the payment
without the option would be $81,250, so B.Lack &
S.Choles will exercise the option and purchase the
euro for 1.2750, which is a payment of $79,687.5
+ premium of $625
If the euro depreciates to 1.2000, B.Lack &
S.Choles will be better of buying euro on the spot
market, so they let the option expire unused. The
payment is then $75,000 + premium of $625
Questions?
Thank you
