Currency options

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Currency options
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Definition

• A contract (agreement)
• Giving a right to buy/ sell
• A specific asset
• At a specific price
• Within a specific time period

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Types of options

• Call option
• Right to buy a currency
• Useful in an appreciating market
• Put option
• Right to sell a currency
• Useful in a depreciating market
• Call and put option may be of two types
• European option can be exercised only on expiry
  date
• American option can be exercised any time upto
  expiry date

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Parties to option contracts

• Purchaser ( trader)
• Has right to exercise (may exercise or may not
  exercise)
• Writer/ seller ( dealer or speculator)
• Has obligation to perform (when purchaser
  exercises the right)

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Options terminology

• Premium price paid for buying an option
• Exercise price (also known as strike price)
  price at which option can be exercised

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Options market

• Listed currency options market (organised
  exchange)
• Philadelphia stock exchange (1982)
• Standardised contracts
• Clearing house acts as counter party
• Maturity is fixed Friday preceding third
  Wednesday of March, June, Sept., Dec.
• Over the counter options market
• Inter bank/ bank to customer dealings
• Customised contracts

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Profit or loss on options trading Call option
buyer

• Firm buys 100,000 call options on Euro
• Strike price Rs.60.50 premium Re.0.05
• On maturity if spot rate Rs.60.65, option will
  be exercised
• Profit is Rs.10,000 (100,000Re.0.10)
• If spot rate on maturity is below Rs.60.50,
  option will expire unexercised loss is the
  premium paid (Rs.5000)

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Profit or loss on options trading put option
buyer

• Firm buy 20,000 put options on USD
• Strike price Rs.45.40 premium Re.0.03
• On maturity
• If spot price is Rs.45, option will be
  exercised profit per option is Re.0.37
• If spot price exceeds Rs.45.43, option will
  expire loss is limited to premium of Re.0.03 per
  option

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Uses of option

• Heding
• Speculation

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Hedging through purchase of options

• Importer buys a call option
• To buy a currency in future when it is
  appreciating
• Exporter buys a put option
• To sell a currency in future when it is
  depreciating

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Example of hedging by importer

• Imported goods worth USD 100,000
• Spot rate Rs.45
• Strike price Rs.45 premium Re.0.05
• On maturity
• If spot price is Rs.45.20, option will be
  exercised and savings would be Rs.15,000
• If spot rate is Rs.44.70, option will expire and
  savings would be Rs.25,000

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Speculating with options

• Simple transactions
• Buying call option when currency appreciation
  is expected
• Buying put option when currency depreciation is
  anticipated
• Complex transactions
• Combining two calls or two puts Spreads
  (vertical, horizontal, diagonal)
• Combining a call and a put straddles and
  strangles