Hand outs # 9&10

International IT University Faculty of Information Technologies

Subject: Financial Risk Management Department of Economics & Business
Lecture theme: Foreign Exchange Derivatives Part III Fall Semester
Associate Professor: M.A. Sohrabian, Ph.D. Academic Year: 2018-2019

Foreign Exchange Derivatives (Part – III)

Currency Options Contracts

Another instruments used for hedging is the currency option. Its primary advantage over
forward and futures contracts is that it provides a right rather than an obligation to
purchase or sell a particular currency at a specified price within a given period.

Options Exchanges:
Ø 1982 - Exchanges in Amsterdam, Montreal, and Philadelphia first allowed trading
in standardized foreign currency options.
Ø 2007 – CME and CBOT merged to form CME group
Ø Exchanges are regulated by the SEC in the U.S.

Over-The-Counter Market:
Where currency options are offered by commercial banks and brokerage firms. Unlike
the currency options traded on an exchange, the over-the-counter market offers
currency options that are tailored to the specific needs of the firm.

Currency Call Option

A currency Call Option provides the right to purchase a particular currency at a
specified price (called the Exercise Price or Strike Price) within a specified period. This
type of option can be used to hedge future cash payments denominated in a foreign
currency.
If the spot rate remains below the exercise price, the option will not be exercised,
because the firm could purchase the foreign currency at a lower cost in the spot market.
Conversely, if the spot rate rises above the exercise price, the owner of a call can
exercise the right to buy currency at the strike price.
A fee (or a premium) must be paid for options. However, so there is a cost to hedging
with options, even if the options are not exercised.

Note: If the spot exchange rate is greater than the strike price, the option is in the
money. If the spot rate is equal to the strike price, the option is at the money. If the spot
rate is lower than the strike price, the option is out of the money.
Note: Currency call options are commonly purchased by corporations that have
payables in a currency that is expected to appreciate. Currency put options are
commonly purchased by corporations that have receivables in a currency that is
expected to depreciate.

Factors Affecting Currency Call Option Premiums

C = f (S – X, T, σ)
+ + +

The premium on a call option (C) is affected by three factors:

Spot price relative to the strike price (S – X): The higher the spot rate relative to the
strike price, the higher the option price will be.
Length of time before expiration (T): The longer the time to expiration, the higher the
option price will be.
Potential variability of currency (σ): The greater the variability of the currency, the
higher the probability that the spot rate can rise above the strike price.

Currency Put Option

A Put Option provides the right to sell a particular currency at a specified price
(Exercise Price or Strike Price) within a specified period.
If the spot rate remains above the exercise price, the option will not be exercised,
because the firm could sell the foreign currency at a higher price in the spot market.
Conversely, if the spot rate falls below the exercise price at the time the foreign
currency is received, the firm can exercise its put option.
The buyer of the options pays a premium.
Note: If the spot exchange rate is lower than the strike price, the option is in the money.
If the spot rate is equal to the strike price, the option is at the money. If the spot rate is
greater than the strike price, the option is out of the money.

Factors Affecting Put Option Premiums

P = f (S – X, T, σ)
- + +
Put option premiums are affected by three factors:

Spot rate relative to the strike price (S–X): The lower the spot rate relative to the
strike price, the higher the probability that the option will be exercised.

Length of time until expiration (T): The longer the time to expiration, the greater the
put option premium

Variability of the currency (σ): The greater the variability, the greater the probability
that the option may be exercised.

Some put options are deep out of the money, meaning that the prevailing exchange rate
is high above the exercise price. These options are cheaper (have a lower premium), as
they are unlikely to be exercised because their exercise price is too low.
Other put options have an exercise price that is currently above the prevailing exchange
rate and are therefore more likely to be exercised. Consequently, these options are more
expensive.

Exhibit 1 Contingency Graphs for Currency Options

When deciding whether to use forward, futures or options contracts for hedging, a firm
should consider the following characteristics of each contract:

Ø First, if the firm requires a tailor-made hedge, that cannot be matched by existing
futures contracts, a forward contract maybe preferred. Otherwise, forward and
futures contracts should generate somewhat similar results.

Ø The choice of either an obligation type of contract (forward or futures) or an

options contract depends on the expected trend of the spot rate. If the currency
denominating payables appreciates, the firm will benefit more from a futures or
forward contract than from a call option contract (the call option contract require
an up-front fee, but it is a wiser choice when the firm is less certain of the future
direction of a currency. The call option can hedge the firm against possible
appreciation but still allow the firm to ignore the contract and use the spot market
if the currency depreciates. Put options may be preferred over futures or forward
contracts for hedging receivables when future currency movements are very
uncertain, because the firm has the flexibility to let the options expire if the
currencies strengthen.

Conditional Currency Options

Some currency options are structured with conditional premiums, it means the
premiums is conditional with the actual movements of the currency’s value over the
period of concern.
Conditional currency option has potential advantage and potential disadvantage in
comparative with basic currency options as outlined below:

Potential Advantage:
Is that you may have no payments of premium in some conditions.

Potential Disadvantage:
Is that the premiums which you may pay on conditional currency option will be much
higher than the premiums you will pay on basic currency option.

For example, ABC Company needs to sell British Pounds that it will receive in 60 days.
Assume it can negotiate a traditional currency put options on pounds at which the
exercise price is $1.70 and the premium is $0.02.
Alternatively, ABC company can negotiate with a commercial bank to obtain a
conditional currency option that has an exercise price of $1.70 and a so called Trigger
of $1.74.

ü If the pound’s value falls below the exercise price by the expiration date. ABC
company will exercise the option receiving $1.70 per pound and does not need to
pay a premium for the option.
 ü If the pound’s value is between the exercise price ($1.70) and the Trigger ($1.74),
the option will not be exercised and ABC company may not need to pay the
premiums.
ü If the Pound’s value exceeds the Trigger of $1.74, ABC company will pay a
premium of $0.04 per unit.

ABC company must determine whether the potential advantage of the conditional
option (avoiding to pay premiums under some conditions) outweighs the potential
disadvantage of the conditional option (paying a higher premiums than the premiums
for the traditional put options on British Pounds).
These potential advantage and disadvantage are illustrated in the below mentioned
exhibit:

Exhibit 2 Comparison of Conditional and Basic Currency Options

At the exchange rates below or equal to the Trigger level ($1.74), the conditional
options will result in a larger put to ABC company by the amount of the premium that
would have been paid for the basic option.
Conversely, at the exchange rates above the Trigger level, the conditional option results
in a lower put to ABC company, as its premium of $0.04 exceeds the premium of $0.02
per unit paid on a basic option.
Generally speaking we may have 2 cases for Conditional Currency Options whether it is
conditional currency call option or conditional currency put option:

Ø A conditional put option on £ may specify an exercise price of $1.70 and a

trigger of $1.74. The premium will have to be paid only if £’s value exceeds
the trigger value.

Ø Similarly, A conditional call option on £ may specify an exercise price of $1.70

and a trigger of $1.67. The premium will have to be paid only if £’s value falls
below the trigger value.

The both cases, the payment of the premium is avoided conditionally at the cost of a
higher premium.

European Currency Options Versus American Currency Options

European-Style Currency Options are similar to American-Style Currency Options

except that they can only be exercised on the expiration date. In other words, European-
Style Currency Options must be exercised on the expiration date if they are to be
exercised at all.
European-Style Currency Options do not offer as much flexibility. However, this is not
relevant to some situations, since in the case of premiums, European-style currency
options are preferable as premiums are lower.
For example, If European-Style Options are available for the same expiration date as
American-style options and can be purchased for a slightly lower premium, Thus
corporations may prefer them for hedging.