Class #6, 7: FX Options, page 1

Clas s

Curre n c y Opti o n s

Ch 8

Class #6, 7: FX Options, page 2

INTRODUCTION I am not sure how ma n y of you hav e studie d options befor e and in what det ail. They are very inter e s ti n g securitie s, differe n t from all the oth er financial securities we hav e see n so far for they allow for a non- linear (kinked) patt e r n of retur n s . Also they are are very simple to und e r s t a n d esp e ci ally since you hav e all see n options in real life. et us try and remind ours elv e s abou t thes e e!a m pl e s .

DEFINITIONS A call option is a right to buy the und e rlying security (in our cas e the f!) for a fi!ed price (strike or e!ercis e price) on or befor e a cert ain dat e (ma t u rity dat e). A simple e!a m pl e of this is a rain- check. The nor m al logic will work if the price of the option is "uot e d as #$%&$. 'therwis e, eith er conv er t the price, or think of the call on the #$ as put on the &$, and vice- vers a. Call options Exam p l e of Call op ti o n (uppos e that you went shop pin g during a )*mas sale for a (ony camc or d e r, selling for +,-- - a mus t hav e ite m in toda ys yuppie world and the stor e had run out of this ite m. Then the stor e might issu e you with a rain- check which would per mit you to got back to the stor e within a mon t h and buy the ca mc or d e r for +,--. (uppos e the day you went back to the stor e ca mc or d e r s were selling for +./- the n would you use your rain- check0 1o the rain- check would be worthle s s and you would 2ust throw it aw ay. 3oing back to call options, supp o s e you hav e an option on the 4, with a strike price of +5.,6, and a life of 7 mont h s . This me a n s that during the ne!t 7 mont h s you may buy a 4 by paying +5.,6, and if the 4 is selling for less tha n that the n your option is worthle s s . Thus, c 8 ma! 9( - :, - ; Pay o f f dia g r a m for a call op ti o n <ayoff diagr a m (at mat urity) looks like - see ne!t pag e Put options The story with put options is the similar. <ut options give you the right to sell the und erlying security for a fi!ed price (strike price) on or before a cert ain dat e (the e!pira tio n dat e). Exam p l e of a put

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A simple ex a m p l e of a pu t option is car insur a n c e . (uppo s e you buy a new =>? for +7-,- - - and you hav e it insur e d for +@6,- - - . This me a n s that in the vent of an accide n t you hav e the right to sell the car to the insur a n c e comp a n y for a price of +@6,- - - . #owev e r, if the da m a g e don e to the car is slight and the car is worth +@/,- - - after the accid e n t the n you would obviously not e!ercis e the option to sell your car. Exam p l e of fx put op ti o n 3oing back to options on f!, suppo s e you hav e a put option on the A> with a strike price of +@.--, and a life of 7 mont h s . This me a n s that during the ne!t 7 mont h s you hav e the right to sell your A> for +@. Bou will obviously do this only if the A> price in the mark e t is less tha n +@. 'therwis e, it would be to your adv a n t a g e to throw aw ay the put option and sell the 4 in the open mark e t . Thus, p 8 ma! 9 : - (, - ) Pay o f f dia g r a m for a pu t op ti o n And the payoff diagr a m (at mat urity) for a put option looks like thisC( e e ne!t pag e Durop e a n optionC can be e!ercis e d only at mat urity America n optionC can be e!ercis e d at any time

ADVANTAGES OF OPTIONS OVER FORWARDS AND FUTURES 5. @. 7. Ese options when time of $& is not known - America n options can be e!ercis e d at any time. Ese options when cash- flow is conting e n t , that is, not cert ain ?hen want an asym m e t ric cas h flow patt e r n, that is a knik in the payoff patt e r n . ($omp a r e d to payoff from fwd%futur e s , which are sym m e t ric.)

Dis a d v a n t a g e of using optionsC #ave to cons t a n tly monitor the position, for chan g e s in risk (for delta is not cons t a n t ).

PAYOFF CHARTS et us look at the ways we can combin e options with e!isting positions in f!, and options with options to get differe n t patt e r n of retur n s . This is all very simple, all it re"uir e s is a knowled g e of ,th grad e geo m e t r y. Also, you should go throu g h the hand o u t I hav e given you, and which use s the sa m e kind of grap hic al analysis. Elementary positions ong f! (hort f!

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ong (hort ong (hort

(buy) call (writte n) call (buy) put (writte n) put

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Dleme n t a r y <ostions Long Call Long Put

Short Call

Short Put

Long Spot

Long Fwd

S 0

F0,T

Ratio hedges
Long fwd

Net payoff Write two calls 2 for 1

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Combinations Hedged positions ong f! and write a call (hort f! and buy a put

APPLICATIONS OF OPTIONS AND FUTURES Example 1: Using options to set a ceiling on a fx payment (uppos e a $an+ has to pay 46 m som e ti m e during the ne!t 7 mont h s . To hedg e this the import e r buys a call options on the 4, and the option pre miu m is +-.-@ @ - % 4 , for options with : 8 +5.6-% 4 F5. ?hat option should the import e r buy0 (ince the import e r is has to mak e a 4 paym e n t , he should buy options that give him the right to buy 4C $A options F@. ?hat is the cost incurr e d toda y0 4 6 m . -.-@ @ - 8 +-.55 m F7. ?hat is the ceiling that the import e r has set on the price of the 40 The ma! that he will hav e to pay for each 4 is +.-@ @%4 G +5.6-% 4 8 +5.66 @% 4 FH. ?hat is the act u a l amo u n t that the import e r will pay if the spot rate at the end of 7 mont h s is +5.H.% 40 (ince ( T I :, the options are worthles s and the import e r can do bett e r by buying at the mark e t rate of +5.H.% 4. Thus, his total cost, ignoring time value of the paym e n t s , is +5.H. G +.- @ @ 8 +5..H/ @% 4 F6. ?hat is the act u a l amo u n t that the import e r will pay if the spot rate at the end of 7 mont h s is +5.66% 40 1ow, ( T J : and ther efor e it is worth e!ercising the options. The import e r will pay his ceiling price, +5.6@ @% 4. <ayoff $hart for this stra t e g yC

Example 2: Using put options to set a floor on a fx receivable (uppos e a Kapan e s e comp a n y, >atsus hit a , has to sell $an+ 6- m som e ti m e during the ne!t . mont h s , ans would like to lock in a minimu m L value for this. The price of a put option with a strike price of : 8 L @7-%+ is L H%+ F5. ?hat option should the import e r buy0 (ince >atsus hit a wishes to sell +, it should buy a put option on the +. This is,

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of cours e, the sa m e as wantin g to buy L, and ther efor e , an call option on the L. F@. ?hat is the cost incurr e d toda y0 + 6- m . L H %+8 L @-F7. ?hat is the floor that the >atsus hit a has set on the price of the 40 The min that they will hav e to receive for each + is 8 : - pre mi u m 8 L @7- - LH 8 L @@.%+ FH. ?hat is the act u a l amo u n t that they receive if the spot rate at the end of 7 mont h s is L @H6%+0(inc e ( T J:, the options are worthle s s and >atsus hit a can do bett e r by selling at the mark e t rat e of L @H6%+, rath e r tha n the e!ercis e price of L @7-%+. Thus, their tot al receipt s will be 8 L @H6%+ - L H%+ 8 L @H5%+ F6. ?hat is the act u a l amo u n t that they receive if the spot rate at the end of 7 mont h s is L @56%+0 1ow, ( T I : and ther efor e it is worth e!ercising the options. >atsus hit a will receive their floor price, L @7- - LH 8 L @@.%+ <ayoff $hart for this stra t e g yC (o far our e!a m pl e s hav e shown how buying options can help in hed gin g f! risk. #owev e r, we can also hed g e f! risk by writin g (sa m e as selling) f! options. Example 3: Writing options to hedge against fx risk. Te!aco, E(A has a large f! e!po s u r e in the form of a $an+ cas h inflow from its $ana di a n oper a tio n s . The risk to Te!aco is that the $an+ ma y depr e ci a t e , ther e b y decr e a si n g the E(+ value of Te!aco* s $an+. Te!aco can reduc e its long position in the $an+ by writing options on the $an+. This strat e g y is called Mfully cover e d call writing. M The adv a n t a g e of this strat e g y is that when Te!aco writes options it receive s a positive cas h flow toda y (from the pre miu m on the options). If the value of the $an+ falls (((+%4) decr e a s e s ) then this positive cas h flow helps offset the loss from depr e ci a tio n. The price of this strat e g y is that if the $an+ appr e ci a t e s , then the option buyer reap s the gains from this - rath e r tha n Te!aco.

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As a financial officer, your 2ob would be to pick the bes t strike price. There is the following trad e- off betw e e n the risk and retur nC As you incre a s e :, the pre mi u m decr e a s e s , so your reve n u e falls, but the chanc e of the options being e!ercis e d agains t you decr e a s e s . As you decr e a s e :, ... <ayoff chart for this stra t e g yC

Example 4: Using options to hedge a contingent CF (uppos e that you sub mit a tend e r to build the new Diffel Tower. Bou are not sure that you will win this bid. If you win the bid, then you will be receiving && cash flows, and ther efor e you would like to buy a put option to hedg e agains t e!ch a n g e riskN but if you do not win the bid you will not hav e any e!ch a n g e risk to hedg e . Thus, you can see that you will not like to be holding a forward contr a c t in cas e you lose the bid. et us e!a mi n e what the optim al e!ercis e policy will be when you buy a put option. There are H possible outco m e s C ( J : ( I : =id acce p t e d do not e!er, get ( T e!er, get : =id re2ect e d do not e!ercis e, get still e!ercis e, get :-(

NOTATION: $, c 8 #$ value of an America n, e u o r o p e a n <, p 8 #$ value of an America n, e u o r o p e a n : 8 strike price t 8 dat e you buy the option T 8 e!piration dat e 8 life of option, T - t =(t, T) 8 curre n t #$ price of a +5 dom e s tic =O(t, T) 8 curre n t &$ price of a &$5 foreign call on on e unit of f! put on on e unit of f!

discou n t bond 8 discou n t bond 8

Bou hav e prob a bly anticipa t e d my ne!t com m e n t that options can be used to hedg e f! risk. They are particularly useful in hedgin g conting e n t cas h flows, or cas h flows whos e dat e is not known with cert ain t y. They are diff er e n t from fwd contr a c t s in that you hav e the choice to e!ercis e the m, unlike the cas e for fwd contr a c t s which you mus t honor. 'f cours e you pay a price for the right to mak e this choice, and this is reflect e d

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in the price ( pre m i u m ) that you pay for a option. >oreov er, their payoff patt e r n is kinked, and they can be e!ercis e d befor e mat urity. D!a mpl e s C (ee below

BASIC PRINCIPLES OF FX OPTION PRICING Simple relationships 5. c,$,p,< - all are J @. At e!pira t tionC c 8 $ 8 ma!( -, ( T - :) and p 8 < 8 ma!( -, : - ( T)

7. Always, $ J cN < J p H. As t incre a s e s the value of the option (call or put) incre a s e s 6. As : incre a s e s , value of a call decr e a s e s , of a put incre a s e s .. A call option on the &$ can be consid er e d a put option on the #$ 7. Put- call parit y rela ti o n s h i p for fx op ti o n s <ortfolio 5. (ell put @. =orrow &$, conver t to #$ 7. =uy call H. end <P(:) Total Therefor e, p G =O( - c - := 8 - , or p G =O( 8 c G := Thus knowing thre e ter m s , you can get the fourth. $& toda y( t) Gp =O( t -c -:= ? $& at >aturity (T) if S T < K if S T > K -(:-() -( -( G: G(- : G: