How options are used to cover foreign exchange risks?

Currency options provide corporate treasurer another tool for hedging foreign exchange risks arising out of firms operations. Unlike forward contract, options allow the hedger to gain from favorable exchange rate movements, while been unprotected from unfavorable movements. However forward contracts are costless while options involve up front premium cost. Examples are:

a) Hedging a Foreign Currency with calls.

In late February an American importer anticipates a yen payment of JYP 100 million to a Japanese supplier sometime late in May. The current USD/JYP spot is 0.007739 (which implies a JYP/USD rate of 129.22.). A June yen call option on the PHLX, with strike price of $0.0078 per yen is available for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million. Premium per contract is therefore: $(0.000108 * 6250000) = $675.

The firm decides to purchase 16 calls for a premium of $10800 .In addition there is a brokerage fee of $20 per contract. Thus the total expense in buying the option is $11,120.The firm has in effect ensured that its buying rate for yen will not exceed $0.0078+ $(11120/100,000,000)= $0.0078112 per yen.

The price the firm will actually end up paying for yen depends on the spot rate at the time of payment .For further clarification the following 2 e.g. are considered:

  • Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late May when the payment becomes due .The firm will not exercise its options. It can sell 16 calls in the market provided the resale value exceeds the brokerage commission it will have to pay. (The June calls will still have some positive premium) .It buys yen in the spot market .In this case the price per yen it will have paid is $0.0075 + $0.0000112 – ${(Sale of value options — 320) /100000000}

If the resale value of the options is less than $320, it will simply let the options lapse .In this case the effective rate will be $0.0075112 per yen or yen 133.13 per $. It would have been better to leave the payable uncovered. The forward purchase at $0.0078 would have fixed the rate at that value and would be worse than the option.

  • Yen appreciates to $0.08

Now the firm can exercise the options and procure the yen at the strike price of $0.0078.In addition, there will be transaction cost associated with the exercise. Alternatively, it can sell the option and buy the yen in the spot market. Assume that June yen calls are trading at $0.00023per yen in late May. With the latter alternative, the dollar will be $800000- $(0.00023 * 16* 6250000)+ $320= $777320. Including the premium, the effective rate the firm has paid is $(0.0077732+0.0000112) = $0.0077844.

b) Hedging a receivable with a put option

A German chemical firm has supplied goods worth Pound 26 million to a British customer. The payment is due in two months. The current DEM/GBP spot rate is 2.8356 and two month forward rate is 2.8050. An American put option on sterling with 3 month maturity and strike price of DEM 2.8050 is available in the inter bank market with a premium of DEM 0.03 per sterling. The firm purchases a put option on pound 26 million .The premium paid is DEM (0.03 * 26000000) = DEM 780000. There are no other costs.

Effectively the firm has put a floor on the value of its receivable at approximately DEM 2.7750 per sterling (= 2.8050-0.03). Again two e.g. are considered:

  • The pound sterling depreciates to DEM 2.7550 .The firm exercises its put option and delivers pound 26 million to the bank at the price of 2.8050. The effective rate is 2.7750. It would have been better off with a forward contract.

Sterling appreciates to DEM 2.8575. The option has no secondary market and the firm allows it to lapse. It sells the receivable in the spot market. Net of the premium paid, it obtains an effective rate of 2.8275, which is better than forward rate. If the interest forgone on premium payment is accounted for, the superiority of the option over the forward contract will be slightly reduced.

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