Hedging with Currency Options

1
Hedging with Currency Options

• An American firm has 1,000,000 payables
  3months hence. Today the market rates are
• Spot 1.3825/1.3830
• 90day forward swap points 20/15
• 90day denominated call options
• Premium (p) 29.50
• Strike Price (X) 138.55

2

• Before going into details of the case study we
  should be careful about the interpretation of the
  quotations of options.
• In options market premium and strike price for
  dollar denominated contracts are given in cents
• So in our problem
• Premium(p) 29.50 cents i.e. 0.2950/100
• Strike Price (X) 138.55 cents i.e. 1.3855
  /

3

• The American firm has three alternatives to deal
• with the foreign exchange exposure
• Open Position
• Forward Hedge
• Option Hedge

4

• At maturity, assuming spot rate as ST ,under
  different
• alternatives the outflow will be
• Open Position
• 1,000,000 ST
• Forward Hedge
• Forward Rate 1.3830
  0.0015
• 
  1.3815
• Outflow 1,000,000 1.3815 1,381,500

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iii) Options Hedging Case 1 If ST gt X Premium
One contract in involves 10000. So
to purchase 1,000,000 , 100contracts are
needed. Premium for 1 contract 10000
0.2950/100
29.5 So for 100 contracts 100 29.5
2950
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Premium is paid at Upfront. But Exercising
the option may be done after 90days. So
assuming 10p.a interest for 90 days the maturity
value of this premium will be 2950 2950
90/365 10/100 3023(apprx) At maturity two
cases may happen Case 1 If ST gt X Case 1 If ST
lt X
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Under Case 1, Option will be exercised and
the outflow in Options hedging will be
1,000,000 1.3855 3023 1,388,523 Under
Case 2, Option will not be exercised and the
outflow in Options hedging will be 1,000,000ST
3023 in
8
So at maturity assuming spot rate ST the
outflows under different alternatives are Open
Position 1,000,000 ST Forward Position
1,000,000 x 1.3815 1,381,500 Option
Position 1,000,0001.3855 3023 1,388,523
(if STgtX) or 1,000,000ST 3023 (if STltX)
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Break Even Point between different
alternatives Break even point between any two
alternative is that point where outflow is same
i) Open position and Forward position
1,000,000 ST 1,381,500 So these two
positions are equivalent when ST becomes equal to
forward rate determined at time t 0, here
1.3815 /. If STgt 1.3815, the forward hedging
will be preferable.
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ii) Open position Option position 1,000,000
ST 1,000,0001.3855 3023 So ST 1.3885 As
long as ST lt 1.3885 open position will
be Preferable As soon as ST gt 1.3885, Option
will be exercised and it will be preferable
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iii) Forward position Option
position 1,000,0001.3815 1,000,000ST 3023
So ST 1.3785 At lower spot value at maturity
than this option is preferable than forward,
because of its one way privilege-the firm can buy
euro in open market letting the option lapse.