OPTIONS Besides forward and future contracts, there is an additional market where

OPTIONS Besides forward and future contracts, there is an additional market where

future foreign currency assets and liabilities may be hedged; it is called the options market. A foreign currency option is a contract that provides the right to buy or sell a given amount of currency at a fixed exchange rate on or before the maturity date (these are known as “American” options; “European” options may be exercised only at maturity). A call option gives the right to buy currency and a put option gives the right to sell. The price at which currency can be bought or sold is called the strike price or exercise price.

The use of options for hedging purposes is straightforward. Suppose

a U.S. importer is buying equipment from a Swiss manufacturer, with a CHF1 million payment due in June. The importer can hedge against a franc

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Puts Strike Price

Calls

Mar

Jun

Mar

Jun

96 International Money and Finance

Exchange. However, large multinational firms often buy options directly from banks. Such custom options may be for any size or date agreed to and therefore provide greater flexibility than is possible on organized exchanges.

Figure 4.3 shows the options quotes for the Swiss franc for maturities in March and June. The quotes are from 2/28/2011 when the spot Swiss franc value was $1.0764. The first column in the figure shows the strike prices available. Each strike price has a cost in terms of cents per Swiss franc for a call or put option in the remaining columns. For example, a put option due in March would be quoted in the third column.

Returning to our trader who has a payment of CHF1 million in June, the liability in June is presently costing the company $1,076,400 (CHF1 million @ $1.0764). If the franc appreciated to $1.10 over the next three months, then using the spot market in three months would change the value of the imports to $1,100,000 (CHF1,000,000 @ $1.1), an increase in the cost of the imports of $23,600. A call option will provide insurance against such change. But there are many options to choose from. If we are only interested in a substantial increase in the value of the Swiss franc, we should choose a higher strike price because it is cheaper. If we cannot tolerate much movement at all, we would pick a lower strike price, but

be willing to pay a higher upfront cost. For example, if we choose to pro- tect ourselves against a substantial movement in the Swiss franc we might choose 1090 as a strike price. This strike price would give us the right to buy Swiss francs at $1.090. It will cost us 1.92 cents per Swiss franc. Thus, the CHF125,000 contract would cost us $2,400 (1.92/100

3 125,000). However, we need eight contracts to cover our liability so the total cost for the option cover is $19,200.

With the options contract, we can now avoid any increase in the cost of the currency above 1.09, and at the same time take advantage of any reduction in the cost of the Swiss franc. For example, if the Swiss franc falls in value to $1.00, we can throw our option and buy Swiss francs on the spot market in 3 months at a cost of $1,000,000, a savings of $76,400 from our initial liability. But having the option not to exercise the trade comes at a cost. Even if we throw the option contract away, we still have

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with a strike price of 1065, then this contract can already be exercised to buy cheap currency. By exercising the option the importer can already buy Swiss francs at $1.065, and could then turn around and sell them on the spot market for $1.0764. This type of contract is “in the money” and would cost more than a contract that is not “in the money.” Similarly a strike price that is above the current spot rate would be “in the money” for a put option.

If we knew with certainty what the future exchange rate would be, there would be no market for options, futures, or forward contracts. In an uncertain world, risk-averse traders willingly pay to avoid the potential loss associated with adverse movements in exchange rates. An advantage of options over futures or forwards is greater flexibility. A futures or forward contract is an obligation to buy or sell at a set exchange rate. An option offers the right to buy or sell if desired in the future and is not an obligation.