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