Foreign
exchange risk management(Part 3)- Hedging with options
1.
Foreign exchange option
This is an instrument that gives
you the choice as to whether to buy/sell a foreign currency at a future date. An
instrument is a sheet of paper that evidences something. If you buy options from
someone, the documentary evidence is an “instrument”.
2.
Choice
It is not compulsory to exercise
your option. You will only do so if it is favourable to you unlike a forward contract.
For example, Liverpool has an option to buy
Jordon Ibe back from Bournemouth. They will only exercise this option if Ibe’s
market value rises higher than the option’s exercise price. That’s one of the
reasons Madrid bought Morata back.
3.
Premium
A premium must be paid if options
are used. This premium can be very expensive. That’s what discourages companies
from using options to hedge.
The premium is the maximum loss that can be
suffered due to hedging using options.
4.
Types of Options
a. Call
option
A
call option gives you the right to buy a foreign currency at a fixed exchange
rate and at a future date.
b. Put
option
This
gives you the right to sell a foreign currency at an agreed exchange rate and at
a future date.
Call=buy,
Put=sell
5.
Exercise/strike rate
The is the exchange rate at which
you can choose to sell/buy a foreign currency at a future date. It is the rate
stated on the option’s instrument.
6.
In-the-money option
An option is in-the-money if you
will gain from exercising it.
7.
Out-of-the money option
An option is out-of-the-money if
you will lose due to exercising it. It will not make sense to exercise this
option.
8.
At-the-money option
Exercising this option will
neither lead to a gain or loss.
9.
Gain/loss
This can be measured at any day. It
is not only at the exercise date that you can measure whether an option is
in/out/at the money.
Example
You bought a call option on
Monday to buy a Dollar on Thursday for N350
The spot rates were N300, N350
and N400 on Tuesday, Wednesday and Thursday respectively.
On Tuesday, the option was
out-of-the money because you could buy a dollar at a cheaper price in the FOREX
market.
On Wednesday, the option was at-the-money
because the strike rate was equal to the spot rate. So, no gain, no loss.
The option was in-the-money on
Thursday because the you could gain by exercising it. If you exercised it, you
will have bought a dollar at cheaper price than you could have bought it in the
FOREX market. So, your gross gain will be N50.
To get your net gain, you have to deduct the
option premium you paid.
10.
Exchange-Traded Option
This is an option that you can
buy in the market. The market for options is known as the options- exchange
just like the market for futures is the futures exchange.
11.
Over-the-Counter Option
This is an option that you buy
from the bank. The calculation for this one is more straight-forward.
12.
Relative merits of exchange traded-options
i.
They
can easily be sold in the market if not required
ii.
No
time is wasted negotiating with a bank
13.
Relative merits of Over-the-counter
options
i.
They
can be used for exact-hedging
ii.
Can
be used to hedge larger amounts and and hedge for longer periods of time
14.
Hedging
If you buy a dollar, you give out
naira. That means that you are selling Naira. The currency you receive is what
you are buying and the one you give out is what you are selling.
15.
Question- Over-the-Counter Option
You have an Over-the-Counter put
option to sell $1000 at N200/$1. The option premium is N5,000. Determine the
amount of Naira you will actually receive if the spot rate on the exercise date is
N250/$1?
You have to option to sell the
dollars at the rate of N200/$1. The means that for every dollar you sell, you
will receive N200.
The price at which you can sell
the dollars in the market is N250/$1. You can make more money by selling the
option in the market, so, the option shouldn’t be exercised.
When you eventually sell the
$1000 in the market, you will makeN250,000. This is your gross receipt
When hedge with options, you must
always deduct the option’s premium determine your net payment or receipt. Your
net receipt will be N245,000(N250k-5k). this is what you will go home with.
Premium reduces your receipt
because it’s a bad thing and a gain is a good thing. The premium will be added
to your gross payment because they are both negative figures.
16.
Question- exchange-traded option
A European company owes a US
supplier $1,000,000 payable in August. The spot rate is $1-$1.1=E1
The details for $/E E50,000
options (cents per E ) are as follows.
Premium cost per contract
Calls Puts
Strike price June July August
June July August
1 6.34 6.37
6.54 0.07 0.19 0.50
1.05 3.86 4.22 4.59 0.08 0.53 1.03
1.1 1.58 2.50 2.97 0.18 1.25 1.89
Show
how traded currency options can be used to hedge the risk at a strike price of $1.05/E1.
Calculate the Euro cost of the transaction if the spot rate in July is
$1.3-$1.4 to 1 euro
First of all, the company will
have to pay Dollars in May because it is owing $1m. To pay dollars, it has to
buy dollars and sell Euros. The question said we should determine the Euro
cost, so, we have to think in terms of Euros. So, it will be selling Euros. Since,
it will sell Euros, a put option should be bought.
The option price of $1.05 means that the
company has the choice to sell 1 euro for $1.05.
In the market, the company can
sell 1 euro for $1.3. This is because the bank will buy at the cheaper rate.
Therefore, the option is out of
the money and should not be exercised. Euros should be sold in the market.
The gross amount of euros that
will be needed to pay the loan is $1m/$1.3=E0.769m. Now, let’s calculate the
option’s premium.
The formula for calculating the
option’s premium is=
Contract size*Number of Contract
s*Premium cost/contract
We will use the table to
calculate the option.
The first thing is to determine
the number of options to be bought.
The formula is Transaction
amount/Option value
The option value is E50k and the
transaction amount amount is $1m. These two figures must be in the same
currency. The option value is a fixed amount, so, the transaction amount has to
be translated to Euros. The strike rate of the option was bought will be used
because the $1m will be paid on the exercise date of the option.
$1m/$1.05= E0.952m.
So, number of contracts= E0.952m/E0.05m=
19.04 contracts. The number of contracts should be approximated to a whole
number. This is because, you can either buy 0/1/2.... contracts. You can not
buy half. So, the number of put options to be bought is 19.
The date of the put option should
be the payment date. So, 19 August put options will be bought. This makes every
non-August figure in the table irrelevant.
Next, we use the exercise price
to determine the premium. The exercise price is $1.05/E1. Go back to the table
and the pick the premium.
The premium is 1.03 cents/Euro. It
is cents and not Dollars, go back and read the sentence before the table.
We have to convert this to
dollars. 100 cents are equal to 1 dollar. So, 1.03 cents are equal to $0.0103. This
is the premium cost/ dollar. We now have everything we need.
Total premium= $0.0103*19
contracts*E50,000=$9,785.
The currency of the premium is
the currency of the premium/contract. In this case, it was dollars.
The question asked for the Euro
cost of the transaction, so, this premium has to be converted to Euro. Premium is
paid when the option is bought. So, the spot rate on that date will be used.
The premium is quoted in dollars.
So, you have to buy dollars to pay it. Therefore, you have to sell Euros to the
bank to buy dollars.
The bank will buy your euros at
the cheaper rate, so, the exchange rate for the premium is $1.
The convert the premium to Euros=
$9,785/$1= E9,785.
The net cost in euros will be the
gross cost+premium= E769,000+E9,785= E778,785.
17.
If the option is exercised
In the above example, the option
was not exercised because it was out-of the money. Assuming the option is
exercised:
the gross payment= Number of options*option
value=19*E50,000=E950,000. The premium will be deducted as usual.
The gain/loss incurred due to not
using usual the exact number of contracts required also has to be
added/deducted. The gain or loss= transaction value-gross payment. These two
figures must be in the same currency.
The transaction value is $1m.
The gross payment is E950,000. This
payment will actually be made on the exercise date of the option, so, the
exercise rate will be used to translate it to dollars.
=E950k*1.05=$997.5k.
The gain earned due to hedging
using the options is $1m-$0.9975m=$0.0025m
So,net cost= E950k-25k+9.785k=
E934.785k.
The premium remains the same. The
gross payment is standardized and you have to determine any net gain/loss
18.
Conclusion
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