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Slide 1:
Last week we learnt about capital structure linking to theory of
repatriation tax & foreign tax credit. This week, we will be learning about
currency options.
Delta hedging in options trading: not related to final exam.
Slide 2:
The difference between an option and forward is that a forward is an
obligation/promise. If you make a promise, you have to keep it otherwise
you go bankrupt.
Option is a right. It is up to you whether you want to exercise the option
if you want. You can exercise the option if it makes you a profit. You
don’t have to exercise if you are going to make a loss.
Call option: gives the holder the right to purchase an asset
Put option: gives the holder the right to sell an asset
Slide 3:
This is an example to show the difference between a forward, call option
and put option.
Call Option
Put Option
N Reversal of the signs
N (K - ST) = Net payoff
N x ST Important: When the payoff of the
forward contract is negative, then the put
N (K - ST) option payoff is 0.
Slide 4:
If you draw a graph of these payoff functions, you get these graphs.
Strike price is given as 1.0. If the exchange rate at maturity is equal to
strike price, the net payoff is 0.
The underlying value of the asset will increase with the spot rate at
maturity, which means the payoff from the forward contract to buy the
underlying asset will increase too.
If the payment of the forward contract is negative, the payoff from the
call option becomes 0. Same thing goes for put option too.
If you buy a call option, there must be a seller. The seller will pay what
the buyer receives. If you buy an option, there is always an upside
probability, no chance of loss. If you sell an option, there is only a
downside potential. However there is never “free lunch”.
Slide 6:
1. NPV of every transaction has to be zero. If you buy an option, there is
only upside potential, but you have to pay a price, which is known as the
option premium.
Slide 7:
If the exchange rate = 1.1, then the call’s payoff will be 100 and the
put’s payoff will be 0.
If the exchange rate = 0.9, then the call’s payoff will be 0 and the put’s
payoff will be 100.
NPV is defined as the sum of discounted future cashflows. You use
this equation to determine the option premium. The interest rate of 4% is
used to discount the cashflows.
Option premium will be 49.80 in both situations.
Slide 9: Volatility
Exercise price is the same.
Volatility as the exchange rate moves up or down by 20%. The new
possible exchange rates are 1.2 and 0.8.
Both the new call and put option premium is 99.60.
Slide 10:
The maturity of option is now 2 months and not 1 month.
There is ¼ probability you will reach the top exchange rate of 1.21.
There is ½ probability you will reach the middle exchange rate of 0.99.
There is ¼ probability you will reach the top exchange rate of 0.81.
Therefore the new premium is 52.08.
When time to maturity increase, the price of both call and put options
will increase.
Slide 12:
In one month, if exchange rate moves up to AUD1.1/USD.
Strategy 1: 1000 x 1.1 = 1100 AUD, which gives a 10% return.
Strategy 2: The payoff form the call option is equal to 2000. Now your
investment return is 100%.
Options are like borrowing money from the bank to buy more assets.
Slide 13:
We have already learnt 4 ways of hedging currency risk exposure
Renegotiation
Sell project in secondary market
Use money market
Use forward contract
Slide 2:
Suppose you have negative cashflow of 1million Pounds in time 1.
Slide 3:
You have to make forward contract to hedge the above underlying asset
(-1,000,000 Pounds). In this forward contract you are going to buy
1million British pounds in the future to hedge the exposure. As a result
the value of this contract is given by this graph.
Slide 5:
CME is the largest exchange for options.
The exercise price of this option will be 1.6. This is a call option.
There are 2 types of options: American (you can exercise whenever you
want even before maturity) and European (you can only exercise at
maturity). It is actually not optimal to exercise early as option has time
value with maturity.
Nominal amount of the contract is 62,500 pounds.
Slide 6:
The first column shows exercise price from 1.58 to 1.62.
Example to buy a call option: To buy one British pound in October at the
exercise price of 1.6, you have to pay 8 cents.
Table has price of call and put options in cents.
High maturity implies higher price.
Slide 7:
For call option, when exchange rate is higher than exercise price, it is ‘in
the money’. When exchange rate is lower than exercise price, it is ‘out
of the money’. For put options, it is the opposite of these relationships.
Slide 8:
Typo: they have used the October exercise price but they should have
used December prices. Revised number below.
Suppose option premium is given as 8cents. 8cents x nominal amount
of 62,500 = 5000 at time 0.
Option premium = ($0.08/£)(£62,500) = $5,000 (cost to buy)
Exercise price = ($1.60/£)(£62,500) = $100,000 (cost to exercise)
If you sell the Pounds back to money market, you will receive £110,000.
Long is about buying and short is about selling.
Slide 11:
You can switch a call and put option with each other.
Slide 12:
If you combine a long call and short put, you get the same result as a
long forward.
Slide 15:
A option value has two components: Intrinsic value and Time value
Time value is always positive as the upside potential dominates.
This is why it is not optimal to exercise American option to exercise
before maturity, as you will sacrifice time value of money. You would
prefer to sell to outside investors instead of exercising to receive time
value of money.
Slide 26:
Black Scholes equation assumes that the volatility doesn’t change.
Before the Lehmann Brothers bankruptcy, VIX increased. It means the
volatility is changing all the time.
1. Binominal tree
2. Monte Carlo simulation