FX Options(II) : Engineering New Risk Management Products Option II 5/2/2019 FX Options(II) : Engineering New Risk Management Products Dr. J. D. Han King’s College, UWO

1. Straight FX Options: “Vanilla” Option II 5/2/2019 1. Straight FX Options: “Vanilla” In a 2-Currency case, One currency Call = the Other Currency Put as you buy one currency and sell the other currency. Example: USD call/JP Yen put “Face values in dollars = $10,000,000 Option call/put = USD call or JPY put Option Expiry = 90 days Strike = 120.00 Exercise = European” The buyer of this option has a right to buy USD $10 million by delivering JP Y 1,200 millions (USD call); He has a right to sell his JP Y 1,200 million for USD $1 (JPY put). This option will be exercise only when the actual price of a US dollar in terms of Yen goes above 120.00.

2. Creating New Products Combining existing instruments Option II 5/2/2019 2. Creating New Products Combining existing instruments Restructuring existing instruments Applying existing instruments to new markets

3. Combining Options with Forwards Option II 5/2/2019 3. Combining Options with Forwards Allows hedge against unfavorable outcome Allows retention of possible benefits Three types of forward options are common Break forwards Range forwards Participating forwards Most common in Foreign Exchange Markets

1) Break Forwards Modifies forward to have features of a Call Option Option II 5/2/2019 1) Break Forwards Modifies forward to have features of a Call Option Premium is paid “implicitly” The buyer can ‘break’ or ‘unwind’ the forward contract at a position where St+1 < X.

Break Forward Payoff $/£ Break Forward Typical Forward Contract Rate Option II 5/2/2019 Break Forward Payoff Break Forward Typical Forward Contract Rate $/£ 1.40 1.45 1.50 1.55 1.60 Contract Rate Price where owner may ‘break’ (unwind)

2) Range Forward A forward contract with limited gain & loss Option II 5/2/2019 2) Range Forward A forward contract with limited gain & loss Major merit: Low Cost Also known as A flexible forward Forward band Collar Cylinder Long Put + Short Call

Option II 5/2/2019 Long Collar Which one to choose depends on the Initial FX risk of the hedger.

Option II 5/2/2019 Short Range-Forward Long Put S1 Short Call

It is called Cylinder = Option fence = collar = range forward. Option II 5/2/2019 A collar is an interesting strategy that is often employed by major investment banks and corporate executives. This position is made by selling a call option at one strike price and using the proceeds to purchase a put option at a lower price. The cost to the investor to make this trade, therefore, is low or close to zero. It is called Cylinder = Option fence = collar = range forward.

Option II 5/2/2019 When this collar or cylinder is used for a long position of any asset(FX), then the net wealth position of the combination of initial FX risks and hedging looks like a ‘Spread’. That is the upside potential modified because of the cost saving actions.

3) Participating Forward Option II 5/2/2019 3) Participating Forward Way to eliminate the “up-front” premium Combine Short Forward position with Long out-of-money Call Short fraction of in-money put

Participating Forward Diagram Option II 5/2/2019 Participating Forward Diagram V Buy 1 Call Resulting Exposure P Combined Option Payoff Sell 1/2 Put Inherent Risk

Option II 5/2/2019 4. Combining Options with Options: ‘Synthetic Options’- Mainly Tools for Speculators Straddle Strangle Butterfly Condor Spread Cylinder = Collar

1) Long “Straddle” Use: Betting on an Increased Price Volatility Option II 5/2/2019 1) Long “Straddle” Use: Betting on an Increased Price Volatility Construction: Long Call and Long Put at the same Strike Price

2) Long ‘Strangle’ Use: the same as ‘Straddle’ but a lower premium Option II 5/2/2019 2) Long ‘Strangle’ Use: the same as ‘Straddle’ but a lower premium Construction: long call and long put at different strike prices

Option II 5/2/2019 3) Long ‘Butterfly’

Option II 5/2/2019 4) Long ‘Condor’

5) Spread: ‘Low or Zero Cost Options’ Option II 5/2/2019 5) Spread: ‘Low or Zero Cost Options’ Bull Spread Long Call at X1 and Short Call at X2 X1 X2 Sell call option and use the premium to buy another call option at a lower strike price: X1 > X2

Option II 5/2/2019 * The farther the two X’s, the larger the upside potential of the bear spread : Compare the two cases:

(2) Bear Spread: Buy Put at X1 and sell Put at X2 Option II 5/2/2019 (2) Bear Spread: Buy Put at X1 and sell Put at X2 Short put X1 Long put X2 Use the premium from short Put in order to buy another Put at a higher strike price X2>X1

Option II 5/2/2019 5. Option Maker by J.D. Han Click here to make the above options by using my option maker(copy-righted)