1. ©1998-20031 Foreign Currency Options II

2. ©1998-2003 1. Using Options for Hedging

3. ©1998-2003 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.

4. ©1998-2003 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

5. ©1998-2003 Expiration: scenario 1 The spot price of CHF at expiration is $0.5790 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

6. ©1998-2003 Expiration: scenario 2 The spot price of CHF at expiration is $0.5820 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

7. ©1998-2003 Expiration: scenario 3 The spot price of CHF at expiration is $0.5920 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

8. ©1998-2003 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”

9. ©1998-2003 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.

10. ©1998-2003 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

11. ©1998-2003 Expiration: scenario 1 The spot price of CHF at expiration is $0.5810 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

12. ©1998-2003 Expiration: scenario 2 The spot price of CHF at expiration is $0.5780 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

13. ©1998-2003 Expiration: scenario 3 The spot price of CHF at expiration is $0.5680 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

14. ©1998-2003 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”

15. ©1998-2003 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.

16. ©1998-2003 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 $0.6922. 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.

17. ©1998-2003 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

18. ©1998-2003 Scenario 1: depreciating CHF July 1 September 1 Spot $0.6922 $0.6542 September futures$0.6956 $0.6558 September 68 long put$0.0059 $0.0250 September 70 long put$0.0144 $0.0447

19. ©1998-2003 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

20. ©1998-2003 Scenario 1: Strategy 3.1 With buying September 68 put options, the company will –loose $4,750 in the spot market –gain $2,387.50 in the option market (exercising the put) –incur a net loss of $2,362.50

21. ©1998-2003 Scenario 1: Strategy 3.2 With buying September 70 put options, the company will gain –loose $4,750 in the spot market –gain $3,787.50 in the option market (selling put) –Incur a net loss of $962.50

22. ©1998-2003 Scenario 2: appreciating CHF July 1 September 1 Spot $0.6922 $0.7338 September futures$0.6956 $0.7374 September 68 put$0.0059 $0.0001 September 70 put$0.0144 $0.0001

23. ©1998-2003 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

24. ©1998-2003 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

25. ©1998-2003 Scenario 2: Strategy 3.2 With buying September 70 put options, the company will –gain $5,200 in the spot market –loose $1,787.50 in the option market (selling put) –net gain of $3412.50

26. ©1998-2003 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$3,412.50 gain

27. ©1998-2003 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