Jones Graduate School Rice University

Masa Watanabe

INTERNATIONAL FINANCE

MGMT 657

CURRENCY OPTIONS AND OPTIONS MARKETS

Currency Options ............................................................................................ 2 Option Hedge .................................................................................................. 6 Option Profit Calculation................................................................................ 7 Currency Option Sensitivities......................................................................... 9 Put-Call Parity............................................................................................... 10 Option Delta and Delta Hedge...................................................................... 11 Practice Problems with Solutions ................................................................. 13

Call

Put

(CME hand signals)

There are two times in a mans life when he should not speculate: when he cant afford it and when he can. Mark Twain

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

CURRENCY OPTIONS A European call option is the right to buy the underlying currency at a specified price (strike price) on a specified date in future (expiration date). A European put option is the right to sell the underlying currency at a specified price (strike price) on a specified date in future (expiration date). Notation Today is date t, the maturity of the option is on a future date T. Std/f : Spot rate on date t, value of currency f in currency d. Kd/f : Strike price id : Interest rate on currency d if : Interest rate on currency f : Volatility of the spot rate C : Price of a call option P : Price of a put option An option is a right and not an obligation, so the payoff to its holder is never negative. At maturity, the holder of a European call option exercises the option and receives the foreign currency (worth $STd/f, the spot rate at maturity) in exchange for the strike price, $Kd/f, only if STd/f > Kd/f. PayoffT$/

Payoff at maturity of a euro call option with strike price $1.12/

At-the-money

Out-of-the-money

In-the-money

$0.25/

K = $1.12/
2

$/

ST$/ $1.37/

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

The holder of a European put option exercises the option and sells one unit of the foreign currency (worth $STd/f) for $Kd/f only if STd/f < Kd/f.

PayoffT$/

Payoff at maturity of a euro put option with strike price $1.12/

At-the-money In-the-money Out-of-the-money

$0.25/

$0.87/

K = $1.12/

$/

ST$/

A European option is exercisable only at expiration. An American option is exercisable any time until expiration. An option is too good to be freeunlike a forward or futures contract, an option has a premium (price) to be paid upon purchase. Note: A forward price or a futures price is a contractual number and not the value of the forward or futures contract (which is zero at inceptionno money changes hand). An option has a positive value at inception (and at any time in its life).

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

WSJ Options Indication (WSJ online 10/30/2007, retrieved in the evening)
Exchange Contract size Maturity

Note: The underlying assets for CME currency options are CME futures contracts.

CME GBP December 2000 call (American) Type of option Underlying asset Contract size Expiration date Exercise price Rule for exercise Premium : a call option to buy GBP : CME December GBP futures contract : 62,500 : 3rd week of December : US$2.000/ : an American option exercisable anytime until expiration : 6.83/, or 62,500 .0683US$/ = US$4,268.75 / contract

Note: In August 2005, CME began trading European-style currency options also.

Most popular strike prices are those around the forward rates. When the strike price of an option is equal to the forward rate, these options are said to be forward at-the-money (forward ATM). Forward ATM options are most liquid options.

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

For a profit-and-loss analysis (as opposed to a payoff analysis), dont forget to subtract the premium (cost). Suppose there are 90 days until the expiration of a European euro call option and the three month $ interest rate (say LIBOR) is 1.2%. If the option premium is 2.14/, its future value is 2.14/ (1 + 0.01290/360) = 2.146 This cost should be subtracted from the payoff (see below). Q2. Why do we compute FV?

ProfitT$/

Profit of the euro call option with strike price $1.12/

At-the-money Out-of-the-money In-the-money

$0.22854/ = 1.37 Strike FV(Premium) BE $1.14146/ FV(Premium) -$0.02146/ K$/ = $1.12/ $1.37/ ST$/

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

OPTION HEDGE Example. Again consider a U.S. distributor who imports wine from France. Its position can be hedged by buying call options.

Import Liability
ProfitT
$/

Call option
ProfitT
$/

ST$/

+
K$/ -FVPrem ST$/

Hedged position
ProfitT
$/

K$/ -FVPrem ST$/ -K$/ -FVPrem

The cost at expiration is at most the strike price plus the future value of the premium. If the distributor can sell the wine at a higher price, it can secure a profit.

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

OPTION PROFIT CALCULATION Consider an exporter to Germany who has a 1 million account receivable due in 6 months. Suppose they hedge their exposure by buying the following put option for full coverage: Export Account Receivable : 1 million A/R due : 6 months US$ interest rate : 2%
Profit$ Export Profit$

Put option Strike Premium Time to maturity

Long Put

: $1.25/ : 4.0/ : 6 months

Profit$ Hedged

+
Slope 1 ST$/

1.2096

=
1.25 ST$/

1.2096

-0.0404

1.25

ST$/

Suppose the spot rate at maturity turns out to be $1.20/. The put option is in the money. Exercise the option. The payoff from the hedged position is $1.25/. The future value of the premium is 0.04(1+.02/2) = 0.0404$/. The profit of the hedged position is 1.25 0.0404 = 1.2096$/. The total profit is 1.2096 $/ 1M = $1.2096M. If the terminal spot rate is $1.30/, the put option is out of the money. exercise. The payoff from the hedged position is $1.30/. The profit of the hedged position is 1.30 0.0404 = 1.2596$/. The total profit is 1.2596 $/ 1M = $1.2596M. Do not

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

Option value = Intrinsic value + Time value Intrinsic value = Value if exercised immediately Time value can be considered the value of insurance.
Call value

High volatility Low volatility

Time value Intrinsic value

Spot rate

The higher the volatility, the higher the option value. Intuitively, the insurance provided by the option is more valuable:

Currency call option value

Call option value

Time value Intrinsic value

Exchange rate

Exchange rate distribution

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

CURRENCY OPTION SENSITIVITIES (For American options)

Spot FX rate Strike price Domestic interest rate Foreign interest rate Volatility Time to expiration

Call

Put

Q3. Why does a call option price increase with the domestic interest rate and decrease with the foreign one? (Effects of other variables should be intuitive.)

Q4. Of these six variables, which is unobservable? How do you measure it?

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

PUT-CALL PARITY What happens if you buy a call option and sell short a put option with the same strike price?

Long Call
CallT$/

Short Put
-

ST$/

ST$/

Long Spot
ST$/ K$/

Bond

=
ST
$/

K
$/

ST$/

This is an arbitrage condition that holds strictly in a liquid currency market. Put-Call Parity at Maturity (at T) CTd/f - PTd/f = STd/f - Kd/f where C and P are the prices of a call and a put option, respectively, with the same strike price Kd/f. More generally at time t, European Put-Call Parity (at t) Ft d/f K d/f S td/f K d/f d/f d/f Ct Pt = = ,T f d 1+ i 1+ i 1 + id

where id and if are the interest rates (prorated, as usual) on currencies d and f, respectively.

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International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

OPTION DELTA AND DELTA HEDGE Option delta is the sensitivity of the option value to changes in the value of the underlying currency. Q5. In the previous picture, what represents the option delta?

Q6. Option delta is positive for a call, and negative for a put. Why?

Q7. Option delta is between 0 and 1 for a call, and between -1 and 0 for a put. Why?

This means the following: suppose the delta of a call option is 0.50.
Delta-hedge the option by a spot contract

: you would short 0.50 spot.

Delta-hedge the option by a futures contract: you would short about 0.50 worth of the futures contract (because the delta of a futures contract is close to 1).

Conversely, if you want to delta-hedge your long 1 transaction (say your export position) by the call option, you would short 2 of the call option.

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International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

Suggested solution to questions
Q1. The first three columns represent call option prices (premiums), because they decrease with strike price. The others are puts. Q2. We should compute the future value because the payoff of an European option occurs at maturity. Q3. We will make only an intuitive argument. Buying and selling the foreign currency at the forward rate is a fair deal in that C = P for options with K = F (see the European Put-Call Parity). If the domestic interest rate rises or the foreign interest rate declines, F will rise by the IRP (K < F), and this makes a call (put) option buying (selling) at K more (less) valuable, i.e., C (P ), and vice versa. Q4. The spot rate volatility is unobservalble. You can measure it, either by historical time series of the spot FX rate (called historical volatility) or by backing out the volatility from prices of traded options using the Black-Scholes formula (implied volatility). Q5. Graphically, option delta is the slope of the option value diagram. Mathematically, this is the first derivative of option price with respect to the spot rate. Q6. Option delta is positive for a call, because the call option price increases with the spot rate. It is negative for a put for the opposite reason. Q7. Graphically, the slope of the call option value approaches to 0 as the spot rate decreases (OTM). It will converge to the 45 degree line as the spot rate tends to infinity (ITM). Contrarily, the slope of the put option value approaches to -1 when the spot rate decreases (ITM), and to 0 when the spot rate becomes very high (OTM).

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International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

PRACTICE PROBLEMS WITH SOLUTIONS
Solve the following end-of-chapter problems from Butler: 6.5 a 7.4, 7.5

Solutions
6.5 a. The optimal hedge ratio for this delta-hedge is given by: NFut* = (amt in futures)/(amt exposed) = - (amt in futures) = (-)(amt exposed) = (-1.025)(-DKr10bn) = DKr10.25bn. So buy DKr 10.25bn, which is equivalent with selling (DKr10.25bn)($0.80/DKr)/($50,000/contract) = 164,000 contracts of the dollar futures.

7.4

The arguments are the same as for call options. As the variability of end-of-period spot rates becomes more dispersed, the probability of the spot rate closing below the exercise price increases and put options gain value. Here are the three sets of graphs:

Spot exchange rate volatility and at-of-the-money put option value

-3

Sd/f
0 1 2 -1

-3

Sd/f
0

-2

-2

13

-1

International Finance

Fall Term II, 2007

CURRENCY OPTIONS AND OPTIONS MARKETS

Spot exchange rate volatility and out-of-the-money put option value

-3

Sd/f
-1 0 1

-3

Sd/f
0

-2

-2

-1

Spot exchange rate volatility and in-the-money put option value

-3

Sd/f
-1 0 1

-3

Sd/f
0

-2

-2

-1

Increasing variability in the distribution of end-of-period spot rates results in an increase in put option value in each case. (For in-the-money puts, the increase in option value with decreases in the underlying spot rate is greater than the decrease in value from proportional increases in the spot rate.) Variability in the distribution of end-of-period spot exchange rates comes from exchange rate volatility and from time to expiration. 7.5 Buy an A$ call and sell an A$ put, each with an exercise price of F1$/A$ = $0.75/A$ and the same expiration date as the forward contract. Payoffs at expiration look like this:

Payoff

Long Call

Payoff

Short Put

Payoff

Synthetic Forward

0.75 0.75 ST$/A$

ST$/A$

ST$/A$

0.75

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