currency option as hedging1 tool

8/6/2019 Currency Option as Hedging1 Tool

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CURRENCY OPTION AS HEDGING

TOOL


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CURRENCY OPTION

Currency options are derivatives contracts in

which foreign currency is the underlying asset.

Currency options are also known as forex

options or Fx options. The contract is between

a buyer and a seller and gives the buyer the

right (but not the obligation) to buy or sell the

underlying foreign currency at a specifiedprice on an agreed upon date in the future


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Two types of currency option

Call option

Put option

The benefits of currency options are: hedging against the adverse movements of

exchange rate

only option contracts that are traded 24 hoursa day.


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How are Currency Options Traded?

Right to buyer but no obligation

the seller of the option is paid a price, known as

premium

strike price.

When an investor believes that US dollar will

appreciate against the Euro, he purchases a

currency call option on USD/EUR. If the value ofthe US dollar actually increases against the Euro,

the buyer can exercise his right to earn a profit.


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HEDGE

A hedge is a financial term denoting an

investment position intended to offset

potential losses that may be incurred by a

companion investment.

Hedge is the technique which supports to

protect or mitigate risk arise on account of

merchandise transactions with overseasmarket, and other currency involved.


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OPTION CONTRACT

An option contract is defined as "a promise

which meets the requirements for the

formation of a contract and limits the

promisor's power to revoke an offer


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TYPE OF CURRENCY OPTION

Put Option :

A currency Put option is an option but not an

obligation to sell currency during a specifiedtime period at a specified price.

Call Option :

A currency Call option is an option but not anobligation to buy currency during a specified

time period at a specified price.


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HOW TO CALCULATE OPTION

CONTRACT

E.G- You have to pay pound 1mn sep-1999.

And need to make sure that your T.C not more

than $1.60/GBP Say you can buy 32 Sep call contracts on the

pound at strike rate $1.58 paying a price 1.98

cent per pound

So 32*31,250 GBP= 1mn Pound


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Option Payoff Diagrams

Buy call: right to

purchase foreign

currency

Buy put: right to

sell foreign

currency

Profit

ForwardRate

+

0

_

BUYCALLOPTION

Strike

Premium

Profit

Forward

+

0

_

SELLCALLOPTION

Profit

Forward

+

0

_

BUYPUTOPTION

Profit

Forward

+

0

_

SELLPUTOPTION

Figure 2. Payoff at Expiration of Options. Eg. buying a call produces a gain if the currency (ie the futures price) rises

above the strike plus the premium; the call writer's profit profile is opposite.


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PARTIES TO OPTION

Buyers have option

Seller do not have option


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PUT CALL PARITY

putcall parity defines a relationship between

the price of a European call option and

European put option

C(t) P(t) = S(t) K *B(t,T)

C(t) P(t) + D(t) = S(t) K *B(t,T) (if Dividend)

Equivalence of calls and Put


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BINOMIAL MODEL

The binomial options pricing model (BOPM)

provides a generalizable numerical method for

the valuation of options

Option valuation using this method is, as

described, a three-step process:


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What is a Binomial Tree?


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Step 1: Constructing a Stock

Price Tree

T


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Step 2: Valuing the Option at

Time of Expiry


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How Do I Value the Option at

Earlier Nodes?


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Step 3: Valuing the Option

Through Backward Induction


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CONCLUSION

Many corporate risk managers attempt to construct hedgeson the basis of their outlook for interest rates, exchangerates or some other market factor. However, the besthedging decisions are made when risk managers

acknowledge that market movements are unpredictable. Ahedge should always seek to minimize risk. It should notrepresent a gamble on the direction of market prices. Awell-designed hedging program reduces both risks andcosts. Hedging frees up resources and allows managementto focus on the aspects of the business in which it has a

competitive advantage by minimizing the risks that are notcentral to the basic business. Ultimately, hedging increasesshareholder value by reducing the cost of capital andstabilizing earnings.

currency option as hedging1 tool

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