1 HEDGING FOREIGN CURRENCY RISK: OPTIONS. 2 …the options markets are fertile grounds for imaginative, quick thinking individuals with any type of risk.

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Presentation transcript:

1 HEDGING FOREIGN CURRENCY RISK: OPTIONS

2 …the options markets are fertile grounds for imaginative, quick thinking individuals with any type of risk profile. The possibility set is limited only by the creativity of the participants… Huge growth in derivatives markets: from 250,000,000 contracts in 1988 to 1,630,000,000 contracts in 2009.

3 Currency options Currency options began trading on the Philadelphia Stock Exchange (PHLX) in 1982 More option exchanges around the world,  more currencies and debt instruments on which options are traded  option contracts with longer maturities  more “styles” of option contracts, and  greater volume of trading activity

4 Types of contracts A call option bestows on the owner the right, but not the obligation, to buy the underlying financial asset or commodity. A put option conveys to the owner the right, but not the obligation, to sell the underlying financial asset or commodity. A European option can be exercised once only at the maturity date of the option. An American option can be exercised at any time on or before the maturity date.

5 Why options?

6 3. While futures contracts allow for the exchange of currencies only at the maturity date, some option contracts (know as ‘American-style’ options) allow the holder to trade at the strike price at any time up to the maturity date. The major benefit of using options in hedging is that they can be used to hedge potential transactions, or transactions that are contingent upon something else.

7 Types of contracts Examples  An American call option on spot € :  The right to buy € 1 million for $1.10 per € from today until expiration on Dec 15,  This “call on € ” is also a “put on US$”.  A European put option on Swiss franc:  The right to sell SFr 10 million March 2002 for $0.65 per SFr on (and only on) Mar 15,  This “put on SFr” is also a “call on US$”.

8 PHILADELPHIA SE EURO/$ OPTIONS €62,500 (cents per €) Strike Price JulAugSep CALLSPUTS Financial Times, June 21, 2000 Previous day’s vol., Calls 265 Puts 28. Prev. day’s open int., Calls 4,111 Puts 888 Contract specifications The buyer of this call option would expect to pay 62,500  $ = $1, plus commission charges. Consider the August 2000 €/$ call option with a strike price of $0.96. The closing price was $ per €.

9 European Call and Put

10

11 Payoff = c T = ??? What if S T = $/Euro? Exercise call (buy 62,500 Euros buy paying $ per Euro). Payoff = 62,500 * ( ) = 3,125$ Profit = 3, ,500 * = 2,618.75$

12 European Call and Put Payoff = c T = ??? What if S T = $/Euro? Do not exercise call. If you do, you end up with losses. Payoff = 0$ Profit = ,500 * = $ Loss = $

13 European Call and Put

14 Long foreign currency call Profit or Loss 0

15 X S Strike Price Profit or Loss 0 Long foreign currency call

16 X S Value of exchange rate at expiration day Profit or Loss 0 Long foreign currency call

17 X S Risk of Loss S T < X Profit or Loss 0 Long foreign currency call

18 X S Possible Profit S T > X Profit or Loss 0 Long foreign currency call

19 0 X S Risk of Loss Possible Profit S T < X S T > X Profit or Loss Long foreign currency call

20 European Call and Put

21 Long foreign currency put 0 X S Profit or Loss

22 0 X S Possible Profit S T < X Profit or Loss Long foreign currency put

23 0 X S Risk of Loss S T > X Profit or Loss Long foreign currency put

24 0 X S Risk of Loss Possible Profit S T < X S T > X Profit or Loss Long foreign currency put

25 Short foreign currency call 0 X S Profit or Loss

26 0 X S Risk of Loss Possible Profit S T < X Profit or Loss Short foreign currency call

27 0 X S Risk of Loss S T > X Profit or Loss Short foreign currency call

28 0 X S Risk of Loss Possible Profit S T < X S T > X Profit or Loss Short foreign currency call

29 Short foreign currency put 0 X S Profit or Loss

30 0 X S Risk of Loss S T < X Short foreign currency put

31 Profit or Loss 0 X S Possible Profit S T > X Short foreign currency put

32 Profit or Loss 0 X S Risk of Loss Possible Profit S T < X S T > X Short foreign currency put

33 Option which would generate profit if exercised immediately is said to be in the money.

34 In the money: S t >X for Calls and S t <X for Puts.

35 In the money: S t >X for Calls and S t <X for Puts. Option which would generate zero profit if exercised immediately is said to be at the money.

36 In the money: S t >X for Calls and S t <X for Puts. At the money: S t =X for Calls and S t =X for Puts.

37 In the money: S t >X for Calls and S t <X for Puts. At the money: S t =X for Calls and S t =X for Puts. Option which would generate losses if exercised immediately is said to be out of the money.

38 In the money: S t >X for Calls and S t <X for Puts. At the money: S t =X for Calls and S t =X for Puts. Out of the money: S t X for Puts.

39 How does it compare to Forwards?

40 Profit or Loss X S Remember that long forward payoff looks like Long forward How does it compare to Forwards?

41 Profit or Loss 0 X S What if we long call... How does it compare to Forwards?

42 Profit or Loss 0 X S What if we long call... Long call How does it compare to Forwards?

43 Profit or Loss 0 X S What if we long call and short put with identical strikes and expiration dates? Short put How does it compare to Forwards?

44 Profit or Loss 0 X S What if we long call and short put with identical strikes and expiration dates? Long call Short put How does it compare to Forwards?

45 What if we long call and short put with identical strikes and expiration dates? Long Forward = { long call + short put } How does it compare to Forwards?

46 Profit or Loss X S Remember that long forward payoff looks like Long forward 0 How does it compare to Forwards?

47 Profit or Loss 0 X S Remember that short forward payoff looks like Short forward How does it compare to Forwards?

48 Profit or Loss 0 X S What if we short call... How does it compare to Forwards?

49 Profit or Loss 0 X S What if we short call and long put with identical strikes and expiration dates? How does it compare to Forwards?

50 Profit or Loss 0 X S What if we short call and long put with identical strikes and expiration dates? How does it compare to Forwards?

51 What if we short call and long put with identical strikes and expiration dates? Long Forward = { short call + long put } How does it compare to Forwards?

52 Profit or Loss 0 X S Remember that short forward payoff looks like Short forward How does it compare to Forwards?

53 Using options OptionsCallsLongShortPutsLongShort

54 Trading strategies

55 X STST Straddle Trading strategies

56 long put... long put X STST Trading strategies

57 long put and long call with the same strike price and expiration date. long call X STST Trading strategies

58 long put and long call with the same strike price and expiration date. long call long put X STST Trading strategies

59 long call long put X STST Straddle long put and long call with the same strike price and expiration date. Trading strategies

60 long call long put X STST Straddle long put and long call with the same strike price and expiration date. Trading strategies

61 long call long put X STST Straddle long put and long call with the same strike price and expiration date. Trading strategies

62 X STST Straddle long put and long call with the same strike price and expiration date. Trading strategies

63 long call and put with the same strike price and expiration date. PriceCall PayoffPut PayoffTotal Payoff S T < X0 X - S T X - S T S T > XS T - X0 S T - X Trading strategies

64

65 STST Butterfly spread Trading strategies

66 Butterfly spread = long call with X 1 X1X1 STST Butterfly spread long call Trading strategies

67 Butterfly spread = long call with X 1 + short call with X 2 X1X1 STST X2X2 short call Trading strategies

68 Butterfly spread = long call with X 1 + short call with X 2 + long call with X 3. X1X1 STST X2X2 X3X3 long call Trading strategies

69 Butterfly spread = long call with X 1 + short call with X 2 + long call with X 3. X1X1 STST X2X2 X3X3 short call long call Trading strategies

70 Butterfly spread = long call with X 1 + short call with X 2 + long call with X 3. X1X1 STST X2X2 X3X3 short call long call Trading strategies

71 Butterfly spread = long call with X 1 + short call with X 2 + long call with X 3. X1X1 STST X2X2 X3X3 short call long call Trading strategies

72 Butterfly spread = long call with X 1 + short call with X 2 + long call with X 3. X1X1 STST X2X2 X3X3 short call long call Trading strategies

73 Butterfly spread = long call with X 1 + short call with X 2 + long call with X 3. X1X1 STST X2X2 X3X3 short call long call Trading strategies

74 Butterfly spread = long call with X 1 + short 2 calls with X 2 + long call with X 3. X1X1 STST Butterfly spread X2X2 X3X3 short call long call Trading strategies

75 Butterfly spread = long call with X 1 + short 2 calls with X 2 + long call with X 3. X1X1 STST Butterfly spread X2X2 X3X3 Trading strategies

76 X1X1 STST X2X2 Strangle Trading strategies

77 Strangle = long put with X 1 long put X1X1 STST X2X2 Trading strategies

78 Strangle = long put with X 1 + long call with X 2 long call X1X1 STST X2X2 Trading strategies

79 long call X1X1 STST X2X2 Strangle = long put with X 1 + long call with X 2 long put Trading strategies

80 long call X1X1 STST Strangle X2X2 Strangle = long put with X 1 + long call with X 2 long put Trading strategies

81 long call X1X1 STST Strangle X2X2 Strangle = long put with X 1 + long call with X 2 long put Trading strategies

82 long call X1X1 STST Strangle X2X2 Strangle = long put with X 1 + long call with X 2 long put Trading strategies

83 long call X1X1 STST Strangle X2X2 Strangle = long put with X 1 + long call with X 2 long put Trading strategies

84 X1X1 STST Bull Spread X2X2 Trading strategies

85 Bull Spread = long call with X 1 long call X1X1 STST X2X2 Trading strategies

86 Bull Spread = long call with X 1 + short call with X 2 short call X1X1 STST X2X2 Trading strategies

87 Bull Spread = long call with X 1 + short call with X 2 long call short call X1X1 STST X2X2 Trading strategies

88 Bull Spread = long call with X 1 + short call with X 2 long call short call X1X1 STST X2X2 Trading strategies

89 Bull Spread = long call with X 1 + short call with X 2 long call short call X1X1 STST X2X2 Trading strategies

90 Bull Spread = long call with X 1 + short call with X 2 long call short call X1X1 STST X2X2 Trading strategies

91 Bull Spread = long call with X 1 + short call with X 2 long call short call X1X1 STST X2X2 Trading strategies

92 X1X1 STST Bear Spread X2X2 Trading strategies

93 Bear Spread = short call with X 1 short call X1X1 STST X2X2 Trading strategies

94 Bear Spread = short call with X 1 + long call with X 2 long call X1X1 STST X2X2 Trading strategies

95 Bear Spread = short call with X 1 + long call with X 2 long call short call X1X1 STST X2X2 Trading strategies

96 Bear Spread = short call with X 1 + long call with X 2 long call X1X1 STST X2X2 short call Trading strategies

97 Bear Spread = short call with X 1 + long call with X 2 long call X1X1 STST X2X2 short call Trading strategies

98 Bear Spread = short call with X 1 + long call with X 2 long call X1X1 STST X2X2 short call Trading strategies

99 Bear Spread = short call with X 1 + long call with X 2 long call X1X1 STST X2X2 short call Trading strategies

100 American Put and Call

101 First of all, American call is more expensive than European call and American put is more expensive than European put. C > c and P > p Why? American style options can be exercised at any time before the date of maturity…which means that they can be AT LEAST exercise the same day as European option is exercised. Having American option gives you more freedom. You have to pay for that!

102 Exotic Options Bermudan Option - early exercise is restricted to certain dates during the life of option. Forward Start Option - options that are paid for now but will start at some time in the future. Employee incentive scheme. Compound Options - Options on Options.

103 Exotic Options “As You Like It” Option - the holder can choose if option is call or put. Barrier Option - the payoff depends on whether the exchange rate reaches a certain level during a certain period of time. Cash-or-Nothing Option - pays off nothing is the stock price ends up above the strike price and pays off cash if it ends up above the strike price.

104 Exotic Options

105 Policy matters As with any derivatives market, a generic question is whether the existence of the option market leads to negative spillover effects, such as an increase in the volatility of the underlying asset. A related public policy concern is the risk to which option traders are exposed and how the capital requirements for those risks should be measured.