Hedging with Foreign Currency Options

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Hedging with Foreign Currency Options

• International Finance GSM 658
• Eli Waite

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Currency Options

• A foreign currency option contract is a
  financial instrument that gives the holder the
  right but not the obligation to sell or buy
  currencies at a set price either on a specific
  date or before some expiration date.
• (The Theory and Practice of International
  Financial Management, Click and Coval, 2002)

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What are they good for?

• Hedging
• Potential transactions
• Transactions that depend on something else
• Uncertain demand
• Quantity Risk
• Limit downside risk, but reap most of the upside.

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Details, Details, Details

• Call Options
• The right to buy a currency at the strike price
• Used to hedge foreign currency outflows
• Put Options
• The right to sell a currency at the strike price
• Used to hedge foreign currency inflows

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Details, Details, Details cont.

• Contract Size 10,000 foreign currency units
  (1,000,000 Yen) (Source http//www.phlx.com/produ
  cts/wco_faq.html3)
• Expiration, the third Friday of the expiration
  month. (Source http//www.phlx.com/products/produ
  ct_specs.html)
• American Options Can be exercised ANYTIME
  before maturity.
• European Options Can ONLY be exercised at
  maturity.

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How it works Put Option

• Source (http//upload.wikimedia.org/wikipedia/en/
  d/d1/PutOption.png)

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How it works Call Option

• Source (http//upload.wikimedia.org/wikipedia/en/
  7/7f/CallOption.png)

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Questions to ask

• Strike Price?
• Maturity?
• American or European?

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Quotes

• Philadelphia Exchange
• http//www.phlx.com/

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Example One

• Pace Co, a cheese and wine store in Salem, OR has
  placed a 20,000 bid for a very rare wine from
  France on March 18. The results of the auction
  will not be known until May. The management team
  at Pace Co is worried that the Euro will continue
  its recent appreciation and would like to lock in
  an exchange rate so that the cost of the auction
  does not get out of hand without having to commit
  to a contract. What should they do?

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Example Two

• Pace Industrials based in Salem, OR has placed a
  bid with the Australian government to be one of
  the sub-contractors to build a bridge to Tasmania
  for AU2,000,000. The winning bid will be
  selected in June (they will be paid at that
  time). The management team is concerned that the
  Australian dollar may depreciate and wants to
  lock in an exchange rate incase they receive the
  contract. What should they do?

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Questions?