© Foreign Currency Options II

© Using Options for Hedging

© The set up (Using calls) A U.S. importer must pay CHF250,000 The payment will occur in late September The importer is concerned that CHF may appreciate against the dollar so that its dollar- denominated payment may increase.

© What to do today? On July 16 the importer can buy 4 PHLX calls on the Swiss francs (CHF62,500 per contract), Pay $2,625 for 4 contracts (1.05 cents per CHF) The strike price X of a call is $/CHF0.58 and its expiration date is in September

© Expiration: scenario 1 The spot price of CHF at expiration is $ Since S < X, Max{(S - X), 0} = 0, the intrinsic (and total) value is 0 The option will not be exercised, i.e. it expires worthless The importer incurs a total loss (or more precisely a hedging cost) of $2,625 which was paid initially for 4 call options The profit for the underwriter (the counterparty of the option contract) is $2,625

© Expiration: scenario 2 The spot price of CHF at expiration is $ Since S > X, Max{(S - X), 0} = $0.0020, the intrinsic value is 0.20 cents per Swiss franc The U.S. importer exercises the option and gets The importer incurs a total net loss (hedging cost) of $2,125: The underwriter’s profit is $2,125

© Expiration: scenario 3 The spot price of CHF at expiration is $ Since S > X, Max{(S - X), 0} = $0.0120, the intrinsic value is 1.20 cents per Swiss franc The U.S. importer exercises the option and gets The importer has a total net gain of $375: The underwriter’s loss is $375

© Call option on a diagram $/CHF spot rate 0.58 Option profit cents/CHF Long call Short call Strike price Profit Loss Limited loss Limited Profit 0 “At the money”

© The Set up (Using puts) An American exporter will receive CHF250,000 The receipt will occur in late September The exporter is concerned that CHF may depreciate against the dollar so that its dollar- denominated cash inflow may be reduced.

© What to do today? On July 16 the exporter can buy 4 PHLX puts on the Swiss Frank (CHF62,500 per contract), Pay $2,225 for 4 contracts (0.89 cents per CHF) The strike price of a put is $0.58 and its expiration date is in September

© Expiration: scenario 1 The spot price of CHF at expiration is $ Since S > X, Max{(X - S), 0} = 0, the intrinsic (and total) value is 0 The option will not be exercised The exporter incurs a total loss of $2,225 which was paid initially for 4 put options The underwriter’s profit is $2,225

© Expiration: scenario 2 The spot price of CHF at expiration is $ Since S < X, Max{(X - S), 0} = $0.0020, the intrinsic value is 0.20 cents per Swiss franc. The U.S. exporter exercises the option and gets The exporter incurs a total net loss of $1,725: The underwriter’s profit is $1,725

© Expiration: scenario 3 The spot price of CHF at expiration is $ Since S < X, Max{(S - X), 0} = $0.0120, the intrinsic value is 1.20 cents per Swiss franc The U.S. exporter exercises the option and gets The exporter has a total net gain of $775: The underwriter’s loss is $775

© Put option on a diagram $/CHF spot rate 0.58 Option profit cents/CHF Long put Short put Strike price Limited loss Limited Profit Profit Loss “At the money”

© Alternative strategies: Forwards and futures Forwards and futures offer a protection against exchange rate risk exposure at the lowest cost. Options offer a protection at a premium. Forwards and futures eliminate any upside (positive) impact of the exchange rate risk. Options do not eliminate the upside (positive) impact of the exchange rate risk.

© The set up (Using options or futures) On July 1, an American company makes a sale for which is will receive CHF125,000 on September 1. The spot price of CHF is $ The firm wants to protect itself against a declining Swiss franc by selling its expected CHF receipts forward (using a futures contract) or by buying (long) a CHF put option.

© The menu of strategies Do nothing and take the risk of declining value of the Swiss Franc mark against U.S. dollar Sell a September futures contract Buy a put option

© Scenario 1: depreciating CHF July 1 September 1 Spot $ $ September futures$ $ September 68 long put$ $ September 70 long put$ $0.0447

© Scenario 1: Strategies 1 & 2 With do nothing strategy, the company will incur a loss of $4,750 With selling short a futures contract, the company will –loose $4,750 in the spot market –gain $4,975 in the futures market –net profit $225

© Scenario 1: Strategy 3.1 With buying September 68 put options, the company will –loose $4,750 in the spot market –gain $2, in the option market (exercising the put) –incur a net loss of $2,362.50

© Scenario 1: Strategy 3.2 With buying September 70 put options, the company will gain –loose $4,750 in the spot market –gain $3, in the option market (selling put) –Incur a net loss of $962.50

© Scenario 2: appreciating CHF July 1 September 1 Spot $ $ September futures$ $ September 68 put$ $ September 70 put$ $0.0001

© Scenario 2: Strategies 1 & 2 With do nothing strategy, the company will have a gain of $5,200 With selling short a futures contract, the company will –gain $5,200 in the spot market –loose $5,225 in the futures market –net loss $25

© Scenario 2: Strategy 3.1 With buying September 68 put options, the company will –gain $5,200 in the spot market –loose $725 in the option market (selling put) –net gain $4,475

© Scenario 2: Strategy 3.2 With buying September 70 put options, the company will –gain $5,200 in the spot market –loose $1, in the option market (selling put) –net gain of $

© The summary table Position CHF depreciates CHF appreciates Unhedged$4,750 loss$5,200 gain Short futures$225 gain$25 loss Long 68 put$2,050 loss$4,475 gain Long 70 put$800 loss$3, gain

© Concluding remarks There is no absolute best hedging strategy The choice of a specific hedge strategy is dictated by many factors, including: amount of foreign currency needed to be hedged –availability of funds for paying the option’s premium –characteristics and availability of derivatives contracts –a company’s expectations about future exchange rate changes –hedging habit & corporate culture