Currency Options

1
Derivatives Session 5
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Foreign Currency Derivatives

• Financial management of the MNE in the 21st
  century involves financial derivatives.
• These derivatives, so named because their values
  are derived from underlying assets, are a
  powerful tool used in business today.
• These instruments can be used for two very
  distinct management objectives
• Speculation use of derivative instruments to
  take a position in the expectation of a profit
• Hedging use of derivative instruments to reduce
  the risks associated with the everyday management
  of corporate cash flow

3
The Nature of Derivatives

• A derivative is an instrument whose value
  depends on the values of other more basic
  underlying variables called bases (underlying
  asset, index, or reference rate), in a
  contractual manner

4
The Nature of Derivatives

• The underlying asset can be equity, forex,
  commodity or any other asset.
• For example, wheat farmers may wish to sell
  their harvest at a future date to eliminate the
  risk of a change in prices by that date. Such
• a transaction is an example of a derivative.
  The price of this derivative is driven by the
  spot price of wheat which is the underlying.

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Examples of Derivatives

• Forward Contracts
• Futures Contracts
• Swaps
• Options

6
The Players in a Derivative Market

• The following three broad categories of
  participants
• Hedgers
• Speculators
• Arbitrageurs
• Some of the large trading losses in derivatives
  occurred because individuals who had a mandate to
  hedge risks switched to being speculators

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Why are they used?

• To discover price
• To hedge risks
• To speculate (take a view on the future direction
  of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without
  incurring the costs of selling one portfolio and
  buying another

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Derivatives in India

• In the Indian context the Securities Contracts
  (Regulation) Act, 1956 (SC(R)A) defines
• derivative to include
• 1. A security derived from a debt instrument,
  share, loan whether secured or unsecured, risk
  instrument or contract for differences or any
  other form of security.
• 2. A contract which derives its value from the
  prices, or index of prices, of underlying
  securities.

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Derivatives in India

• Derivatives are securities under the SC(R)A and
  hence the trading of derivatives is governed by
  the regulatory framework under the SC(R)A.

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Currency Forwards

• A forward contract is an agreement between a firm
  and a commercial bank to exchange a specified
  amount of a currency at a specified exchange rate
  (called the forward rate) on a specified date in
  the future.
• Forward contracts are often valued at 1 million
  or more, and are not normally used by consumers
  or small firms.

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Currency Forwards

• When MNCs anticipate a future need for or future
  receipt of a foreign currency, they can set up
  forward contracts to lock in the exchange rate.
• The by which the forward rate (F ) exceeds the
  spot rate (S ) at a given point in time is called
  the forward premium (p ).
• F S (1 p )
• F exhibits a discount when p lt 0.

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Currency Forwards

• Example S 1.681/, 90-day F 1.677/
• annualized p F S ? 360
• S n
• 1.677 1.681 ? 360 .95
• 1.681 90
• The forward premium (discount) usually reflects
  the difference between the home and foreign
  interest rates, thus preventing arbitrage.

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Foreign Currency Futures

• A foreign currency futures contract is an
  alternative to a forward contract that calls for
  future delivery of a standard amount of foreign
  exchange at a fixed time, place and price.
• It is similar to futures contracts that exist for
  commodities such as cattle, lumber,
  interest-bearing deposits, gold, etc.
• In the US, the most important market for foreign
  currency futures is the International Monetary
  Market (IMM), a division of the Chicago
  Mercantile Exchange.

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Currency Forwards

• A swap transaction involves a spot transaction
  along with a corresponding forward contract that
  will reverse the spot transaction.
• A non-deliverable forward contract (NDF) does not
  result in an actual exchange of currencies.
  Instead, one party makes a net payment to the
  other based on a market exchange rate on the day
  of settlement.

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Forward Market

• An NDF can effectively hedge future foreign
  currency payments or receipts

Index .0018/peso ? pay 20,000 to bank.
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Currency Futures

• Currency futures contracts specify a standard
  volume of a particular currency to be exchanged
  on a specific settlement date.
• They are used by MNCs to hedge their currency
  positions, and by speculators who hope to
  capitalize on their expectations of exchange rate
  movements.

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Currency Futures

• The contracts can be traded by firms or
  individuals through brokers on the trading floor
  of an exchange (e.g. Chicago Mercantile
  Exchange), automated trading systems (e.g.
  GLOBEX), or the over-the-counter market.
• Brokers who fulfill orders to buy or sell futures
  contracts typically charge a commission.

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Foreign Currency Futures

• Contract specifications are established by the
  exchange on which futures are traded.
• Major features that are standardized are
• Contract size
• Method of stating exchange rates
• Maturity date
• Last trading day
• Collateral and maintenance margins
• Settlement
• Commissions
• Use of a clearinghouse as a counterparty

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Foreign Currency Futures

• Foreign currency futures contracts differ from
  forward contracts in a number of important ways
• Futures are standardized in terms of size while
  forwards can be customized
• Futures have fixed maturities while forwards can
  have any maturity (both typically have maturities
  of one year or less)
• Trading on futures occurs on organized exchanges
  while forwards are traded between individuals and
  banks
• Futures have an initial margin that is market to
  market on a daily basis while only a bank
  relationship is needed for a forward
• Futures are rarely delivered upon (settled) while
  forwards are normally delivered upon (settled)

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Comparison of the Forward Futures Markets
Forward Markets Futures Markets Contract
size Customized Standardized
Delivery date Customized Standardized Participants
Banks, brokers, Banks, brokers, MNCs.
Public MNCs. Qualified speculation not public
speculation encouraged. encouraged. Security Com
pensating Small security deposit bank balances
or deposit required. credit lines
needed. Clearing Handled by Handled
by operation individual banks exchange
brokers. clearinghouse. Daily settlements to
market prices.
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An Option is.

• A contract where the buyer has the right, but not
  the obligation to
• Buy/Sell
• Specified quantity of a currency
• At a specified price (strike price)
• By a particular date (expiry date)
• For this right, the buyer pays the seller(writer)
  of the option an upfront fee (called option
  premium)

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Forwards ? Options

• Forwards most common and popular derivative
  instrument for hedging forex exposures.
• Offers best protection against adverse exchange
  rate movements BUT carries risk of opportunity
  loss in the event of favorable movements.
• An Option offers the protection of a forward
  contract but without its commitment.

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Options v/s Forwards

• Options give the buyer a right but no obligation.
• Good instrument to hedge adverse price moves
  avoiding opportunity loss.
• Upfront premium
• Can choose the strike price

• Forwards are fixed price contracts wherein the
  buyer/seller is obligated to the price
• Opportunity loss
• No upfront premium
• Cannot choose the price

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Option Terminologies
Call Option Gives the holder the right but not
the obligation to BUY an underlying at a fixed
price from the writer of the option. Put
Option Gives the holder the right but not the
obligation to SELL an underlying at a fixed price
to the writer of the option
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Two types of option
American Option May be exercised at any time
during the life of a contract. European
Option. May be exercised only at maturity or
expiry date.
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Options - specifications
Strike Price or Exercise price The fixed price
at which the option holder has the right to buy
or sell the underlying currency. Expiry Date
The last day on which the option may be
exercised. Life or Exercise Period The period
of time during which the option holder enjoys the
purchased option contracts.
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Advantage of Option over Forwards

• Forward Contract
• On April 01, importer A buys USD forward at 43.75
  with an expiry date May 31.
• Currency Option
• Same day, importer B buys a USD call option, with
  a strike price of 44.00 at same expiry on 31st
  May and pays a premium of 15 paisa. His worst
  effective rate is now 44.15.
• On May 31
• USD/INR trades at 43.50. Importer A buys Dollars
  at 43.75. Importer B can ignore the option and
  buy USD at the current market rate of 43.50.
• His net cost now works out to 43.500.15 43.65.

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Options example

• USD imports - due 31st May
• Company buys an USD call option with a strike
  price of 43.70 when spot rate is 43.60.
• 2 business days before the expiry date, the
  company has to decide whether or not to exercise
  the option.
• So on 29th May at the specified cut-off time, if
  spot USD is over 43.70, the company will exercise
  the option and buy USD at 43.70
• However, if spot rate is less than 43.70, then
  the company can let the option lapse and instead
  fix the spot rate for the transaction on 29th
  May.

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Options example

• USD exports - due 31st May
• Company buys an USD put option with a strike
  price of 43.70 when spot rate is 43.60.
• 2 business days before the expiry date, the
  company has to decide whether or not exercise the
  option.
• So on 29th May at the specified cut-off time, if
  spot USD is below 43.70, the company will
  exercise the option and Sell USD at 43.70
• However, if spot rate is more than 43.70, then
  the company can let the option lapse and instead
  fix the spot rate for the transaction on 29th
  May.

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Risk / Profit Profile
Buyer
Seller Profit Unlimited Premium
Risk Premium Unlimited
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Option strike price

• In the money (ITM)
• The option is In the Money when the Strike Price
  is favourable to the option holder(buyer) than
  the current forward rate.
• Eg USD put option with strike 43.80 current
  fwd rate 43.75 option in the money
• Out of the money (OTM)
• The option is Out of the Money when the Strike
  Price is unfavourable to the option
  holder(/buyer) than the current forward rate.
• Eg USD call option with strike 43.90 current
  fwd rate 43.75 option out of the money
• At the money (ATM)
• The option is At the Money when the Strike Price
  is equal to the current forward rate.

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Option, Forwards Open Position

• A call option will outperform a forward contract
  when spot rate at maturity plus option premium is
  less than the forward rate.
• A put option will outperform a forward contract
  when spot rate at maturity less the option
  premium is greater than the forward rate.
• As to unhedged positions, a call option will be
  better than an unhedged position only if the
  strike price plus premium is less than the spot
  at maturity.
• Likewise, a put option will be better than an
  unhedged position only if the strike price less
  the option premium is greater than the spot at
  maturity.

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Price of an Option

• Can the Option buyer have the cake eat it too?
• Not really - since the option seller charges the
  buyer an upfront premium payable in cash.
• And the upfront premium can be as high as 1 or
  even more depending on the strike price and the
  maturity period.

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Why Option Premium?

• An option buyer never loses money with reference
  to the strike price but may make or save money.
• The option seller is in an opposite position he
  can have windfall losses.
• Based on the probability distribution of spot
  prices at maturity, there is an expected gain
  or profit to the buyer.
• This is charged as upfront premium.
• Option seller always incurs a loss, while he
  hedges his short option position using
  mathematical hedging techniques
• The loss is recovered by way of the upfront
  premium.

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Option premium - Quotations

• Points of the second currency/terms currency
• or
• Premiums are quoted as a flat percentage of the
  base currency Principal amount
• Example
• USD/INR put 1m
• USD/INR strike price 43.90
• Premium quoted as 0.33 INR
• Or 0.331,000,000 3,30,000 INR
• 330,000 INR 7,569 (330,000/43.60 spot)
• 7,569 is 0.75 of 1m principal

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Factors determining Premium value

• Volatility
• Strike Price
• Life or Exercise Period
• Interest Rates - domestic foreign
• Current Market Rate

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Volatility historic v/s implied

• Volatility is defined as the standard deviation
  over the mean on the returns on prices.
• Historic volatility is the volatility calculated
  using a set of historical data (usually the set
  of data corresponds to the period of the option).
• Implied volatility is the market expectation of
  future volatility.
• Traders in the option market quote the option
  premium, which is then used as an input in the
  Black Scholes option pricing formula to
  calculate the implied volatility.
• Research has proved that option trading affects
  the volatility of the underlying market, causing
  a reduction in most cases.

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Change in premium with change in volatility
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Strike Price Dynamics

• The option premium can be quite high for ATM
  options.
• Is there a way to reduce the premium ?
• There is one golden rule. You cant get anything
  in the market for free.
• So to reduce the premium, you have to give up
  some protection.
• To reduce the premium, you have to raise the
  strike price and consider buying an OTM option
  thereby giving up some protection. The more OTM
  the option is, the lower will be the premium.
  Conversely, the more ITM an option is, the higher
  will be the premium.

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Strike Price

• The more otm the option is, the lower will be the
  premium. Conversely, the more itm an option is,
  the higher will be the premium. For eg USD/INR
  Spot 43.50

• It is seen that the reduction in premium is less
  than the protection sacrificed.

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Choosing the right strike price

• USD/INR spot 43.50 6 months ATM 43.86
• Worst case rate 43.35
• You have USD exports
• Fix the worst case rate (WCR)
• Bearish on Rupee
• You buy an OTM Put with lowest strike so that the
  strike minus premium is above WCR
• Strike 43.70 Premium 0.35 WCR Strike -
  Premium 43.35
• Bullish on Rupee
• You buy ATM USD Put
• Strike 43.86 Premium 0.41, WCR Strike -
  Premium 43.45, which is more than 43.35 (WCR)

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Comparison between Strike Price WCR Pay off
Profile
X axis - Spot at maturity Y axis - Effective rate
Strike 43.70 --gt premium 0. 35 --gt WCR 43.35 --gt
If bearish on Rupee.
Strike 43.86 --gt premium 0.41--gt WCR 43.45 --gt If
bullish on Rupee.
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Option Strategies
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Long USD Call Option
Profit
Profit Unlimited
Strike Price
Price of underlying (USD/INR)
43.90
Loss Area
Cost of Premium
Break-even price
43.900.45 44.35
Loss
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Short USD Call Option
Profit
Break-even price
43.900.45 44.35
Premium Income or Profit
Price of underlying USD/INR
43.90
Loss Unlimited
Strike Price
Loss
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Long USD Put Option
Profit unlimited
43.90 - 0.45 43.45
Break-even price
Price of underlying USD/INR
Cost of Premium
Strike Price
43.90
Loss
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Short USD Put Option
Profit
43.90 - 0.45 43.45
Break-even price
Premium Income or Profit
Price of underlying
Loss Unlimited
Strike Price
43.90
Loss
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Indian Scenario

• In the pre-liberalization era, the insular
  economic environment felt no scope for the
  derivative market to develop.
• Indian corporate depended on term lending
  institutions for their project financing
  commercial banks for working Capital.
• Forward contract was the only derivative product
  to hedge financial risk.
• Post-liberalization India saw developments in the
  instrument forward contract.
• Corporate was allowed to cancel rebook forward
  contracts.

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Why Rupee options?

• Rupee options would enable an Indian corporate to
  hedge against downside risk on FC/INR while
  retaining the upside, by paying a premium upfront
  better competitiveness.
• Hedge against uncertainty of cash flows due to
  NON LINEAR payoff of option for eg. Indian
  company bidding for an international contract
  bid quote in Dollars but cost in Rupees Risk of
  USD/INR falling till the contract is awarded
  forwards will bind the company even if the
  overseas contract not allotted Option contract
  will freeze the liability only to the option
  premium paid upfront.
• Attract more forex investment due to availability
  of another mechanism for hedging forex risk.

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Rupee options why now?

• RBIs earlier concerns
• Poor risk management skills at banks, who would
  be selling options to customers
• Options market may impact the spot rupee
• Current considerations
• Increasing volatility in the rupee makes it
  difficult for corporates to manage risk
• Exchange rate policy appears looser strong
  reserves provides comfort
• Option use is getting more commonplace

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Issues in pricing

• Different banks will use different pricing
  models, although FEDAI is already polling banks
  for implied volatility, which will be available
  on their web-site
• Spread between theoretical price and quoted price
  can be quite high
• Need to shop around

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Your Portfolio

• USD/INR Spot 43.50
• 6 month fwd rate 43.86
• You are an importer
• Worst Case Rate (WCR) 44.40
• 6 month USD/INR volatility 3 / 3.5
• Diff based on Risk free rate 1.65

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Low Cost Option Strategies

• An option buyer can reduce his premium cost by
  selling another option. The combination can
  reduce the cost as the premium received on the
  option sold could either partially or fully
  offset the cost of option bought.
• Different Strategies
• Range Forward
• Participating Forward
• Seagull
• Leveraged forward

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Zero Cost Range Forward (RF)

• Range Forward - involves buying an out of the
  money call/put option with the worst case rate
  as the strike price and selling an out of the
  money put/call option with such a strike price
  (best case rate) that the net premium is zero
• If price at maturity is beyond the wcr the
  bought option will be exercised
• If the price at maturity is beyond bcr the sold
  option will be exercised
• If price at maturity is between the wcr bcr
  you buy or sell at spot
• Although entry is painless, exit could be painful

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Buy USD Call at 44.40, Sell USD Put at 43.50
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Participating Forward (PF)

• Participating forward - involves buying an out of
  the money call/ put option with the worst case
  rate as the strike price and selling an in the
  money put/call option for a reduced amount and
  with the same strike price so that the net
  premium is zero
• In effect there is a synthetic OTM forward
  contract for the amount of the ITM option sold
  and a free OTM option for the balance amount

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Seagull (S)

• Involves buying an out of the money call/put
  option (A) and selling an out of the money
  put/call option (B) also selling a
  far-of-the-money call/put option (C ) so that the
  net premium of the whole portfolio is zero
• If price at maturity is between the strikes of
  (A) and (C), only (A) will be exercised
• If the price at maturity is beyond the strike of
  (B), only (B) will be exercised
• If the price at maturity is beyond the strike of
  (C), both (A) and (C) will be exercised.
• If price at maturity is between the strikes of
  (A) (B) you buy or sell at spot
• This a a variant of the range forward as a
  far-out-of-the-money call/put is sold with the
  range forward to improve the best case rate or
  the strike of (B).

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Leveraged Forward (PF)

• Leveraged forward - involves buying an in the
  money call/ put option and selling an out of the
  money put/call option for an increased amount and
  with the same strike price so that the net
  premium is zero
• In effect there is a synthetic in the money
  forward contract for the full amt with a
  leveraged loss beyond the synthetic ITM forward
  rate (strike price).

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Rupee Options Product specifications

• Vanilla European options combinations thereof
  at introduction. This will continue till banks
  have sophisticated systems risk management
  frameworks to hedge this new non-linear product.
• Over the counter contracts.
• Can be tailored to suit the corporates need.
• FC-INR where foreign currency may be the ccy
  desired by the corporate.
• No minimum amt recommended by RBI.
• Premium payable on spot basis.

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Rupee Options Product specifications..

• Settlement would be either by delivery on spot
  basis or net cash settlement in Rupees on Spot
  basis, depending on the FC-INR spot rate on
  maturity date. (specs will be specified in the
  contract) RBI reference rate could be the
  reference rate for settlement.
• Strike Price Maturity could be tailored to suit
  counterparties needs typical maturities are 1
  week, 2weeks, 1, 2, 3, 6, 9 12 months.
• Exercise style European.

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Uses of Rupee options

• To hedge genuine FX exposures arising out of
  trade/business (Banks may book transactions based
  on estimated exposure for uncertain amounts)
• To hedge FC loans.
• To hedge GDR after the issue price is finalised.
• Balance in EEFC accounts.
• Special cases contingent exposures.
• Derived FX exposure viz FX exposure generated due
  to a asset/liability coupon /or PI swap.

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One hedge for one exposure

• Only one hedge may be booked against a particular
  exposure for a given time period.
• For eg Exporter with USD receivables after 6
  months, can sell a forward for 3 month after 3
  month square the forward book an option for
  another 3 months.
• But the exporter cannot book a forward an
  option for the same exposure at the same time.

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Hedging Rupee Options

• Authorized dealers to be allowed to hedge options
  by accessing the spot market.
• Extent frequency to be decided by dealers.
• ADs to be allowed to hedge Greeks using options.

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Clients as net receivers of premium

• Earlier clients could not receive net premium.
• Now large corporates with aggressive treasury
  operations have been allowed to receive net
  premium as the market matures.
• They can buy as well sell option contracts.

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Barrier options

• These are two types of barriers in options
• - Knock in barrier
• - Knock out barrier
• These can be single barrier or double barrier
  options
• Barriers are American in nature
• Main advantage is smaller upfront premium
  compared to Plain Vanilla option with same strike
  price

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Barrier Options

• A barrier option, also known as knock out option,
  is a type of financial option where the option to
  exercise depends on the underlying crossing or
  reaching a given barrier level.
• Barrier options were created to provide the
  insurance value of an option without charging as
  much premium.
• For example, if you believe that US Dollar will
  go up this year, but are willing to bet that it
  won't go above Rs45, then you can buy the barrier
  and pay less premium than the vanilla option.

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Barrier Options

• Barrier options are path-dependent exotics that
  are similar in some ways to ordinary options.
• There are put and call, as well as European and
  American varieties.
• But they become activated or, on the contrary,
  null and void only if the underlying reaches a
  predetermined level (barrier).

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In and Out

• "In" options start their lives worthless and only
  become active in the event a predetermined
  knock-in barrier price is breached.
• "Out" options start their lives active and become
  null and void in the event a certain knock-out
  barrier price is breached.
• In either case, if the option expires inactive,
  then there may be a cash rebate paid out.
• This could be nothing, in which case the option
  ends up worthless, or it could be some fraction
  of the premium.

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Four main types of barrier options

• Up-and-out spot price starts below the barrier
  level and has to move up for the option to be
  knocked out.
• Down-and-out spot price starts above the barrier
  level and has to move down for the option to
  become null and void.
• Up-and-in spot price starts below the barrier
  level and has to move up for the option to become
  activated.
• Down-and-in spot price starts above the barrier
  level and has to move down for the option to
  become activated.

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Barrier Options (Example)

• A European call option may be written on an
  underlying with spot price of 100, and a
  knockout barrier of 120.
• This option behaves in every way like a vanilla
  European call, except if the spot price ever
  moves above 120, the option "knocks out" and the
  contract is null and void.
• Note that the option does not reactivate if the
  spot price falls below 120 again. Once it is
  out, it's out for good.

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Knock out barrier options

• Knock out options get knocked out (dead or cease
  to exist) only when the spot rate hits the
  specified barrier or either of the two barriers.
• There are two kinds of knock out barriers in
  India
• - Up and out knock out
• - Down and out knock out

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Knock in barrier options

• Knock in options get knocked in (come alive) only
  when the spot rate hits the specified barrier or
  either of the two barriers.
• There are two kinds of knock in barriers
• - Up and in knock in
• - Down and in knock in
• Knock out Knock in options with same strike
  barriers equals plain vanilla option.

76
Euro import portfolio

• You have Euro imports
• EUR/USD Spot 1.2870
• Worst case rate 1.31
• Time 6 months
• 6M Forward rate 1.2920
• Volatility 9.5 / 10
• 6M USD Libor 2.99
• 6M Euro Libor 2.19

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Smart Forward (SF)

• Zero cost exotic hedge
• Plain out of the money option as long as a
  specified in the money trigger is not hit
• Option gets transformed into a out of the money
  synthetic forward contract if the trigger is hit
• If the market view turns out to be wrong, there
  can be an opportunity loss, and
• The SMART FORWARD becomes a DUMB BACKWARD

78
Buy Euro Call at 1.31, Sell Euro Put at 1.31 with
KI at 1.1925
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Choice Forward (CF)

• Zero cost exotic hedge
• Involves buying an in-the-money option with two
  knock out barriers.
• Also simultaneously buying an out-of-money option
  with the same two knock in barriers (A)
• Also selling in-the-money option with same two
  knock in barriers (B)
• (A) (B) put together constitute an
  out-of-money, double knock-in, synthetic, forward
  contract

80
Buy Euro Call at 1.27 with KO at 1.38 1.20,
Sell Euro Put at 1.31 with KI at 1.38 1.20,
Buy Euro Call at 1.31 with KI at 1.38 and 1.20