Application Of Foreign Exchange Options

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The users of the option market are widespread and varied, but the main users are organizations whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange-traded options markets will be accessed by the professional market makers and currency risk managers. The standardization of options contracts promotes tradability, but this is at the expense of flexibility.

In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options to manage currency exposures. Some clients consider options to be expensive and/or speculative. When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help to minimize downside risk, while allowing participation in the upside potential. One of the reasons that clients may choose to use an option instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements. (This is shown graphically in Figure 14.1.)

Companies use currency options to hedge contingent/economic exposures, to hedge an existing currency exposure, and possibly to profit from currency fluctuations, while funds may use options to enhance yield.

A simplified decision tree on when to use options, or the various other products available, can be quite useful. The decision-making process assumes a firm view of likely future rate movements, as indecisiveness can only be accommodated by the use of currency options, which can be an expensive solution for many hedging requirements. The more confident the forecast, the simpler the products needed to satisfy needs. The simpler the product, the cheaper the cost. If the forecast is confident that rates will be favourable, then it is best to stay unhedged or to take out an option with the full confidence that the premium cost will be recovered, as the option means that any unexpected downturn will be catered for. Similarly, if no change is expected, then the position should be covered with the cheapest hedge possible. A confident forecast that rates will be unfavourable would call for a forward contract. An example of an exposure management decision tree is shown as in Figure 14.2.

Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.

1. Do nothing: potential loss or gain

2. Forward forex contract: no potential loss or gain

3. Purchase an option - loss limited to premium paid while retaining upside potential

Figure 14.1 Foreign exchange considerations

— Move favourably

Do nothing

■ Use currency option

If foreign exchange rates are expected to

Be unchanged from present levels

Forward foreign exchange contract

Move unfavourably

Arbitrage foreign ■ exchange and money markets

Figure 14.2 Exposure management decision tree

Hence, the purchase of a currency option may help by limiting the downside currency fluctuation risk while retaining the upside potential, by providing unlimited potential for gain, by providing a hedge for a contingent risk, and by enabling planning with more certainty. On the other hand, selling a currency option may assist in providing immediate income from premium received and provides flexibility when used with other tools as part of an exchange rate strategy.

In general, the applications of foreign exchange options can be summarized as follows.

• To cover foreign exchange exposure:

- on existing exposure

- on contingent exposure

- against a budget rate

- as disaster insurance

- on the direction of spot

- on a volatile or quiet market

- on the timing of spot movement

- on changing interest rate differentials

- as an investment:

in a speculative asset or to alleviate loan costs or to improve deposit yields

- as a funding tool:

to generate a cash flow (short position) or to transfer cash to another entity

- as a tax management tool:

to transfer profit and loss over time.

For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By purchasing a call (the right to buy) the maximum cost can be fixed for a purchase and by purchasing a put (the right to sell) the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavourable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favourable moves.

In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from the expectation that volatility will either increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of $/Sfr 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months' time.

The trader has two choices: to hold the option to expiry, and if the spot rate has risen to, for example, $/Sfr 1.73, the trader would exercise his right to buy dollars and sell Swiss francs at 1.6835, and hence, make money. If the spot rate is below $/Sfr 1.6835 at expiry, then the maximum loss is limited to the premium paid for the option. Alternatively, if the spot rate

Table 14.1 Forex options versus forex forwards Options

Right but not the obligation to buy or sell a currency

Premium payable

Wide range of strike prices

Retains unlimited profit potential while limiting downside risk

Flexible delivery date of currency (can buy an option for a longer period than necessary)

Forwards

Obligation to buy or sell a currency No premium payable

Only one forward rate for a particular date

Eliminates the upside potential as well as the downside risk

Fixed delivery date of currency

Table 14.2 Forex options versus forex open positions

Option

Open position

Right but no obligation to buy or sell a currency Premium payable

Retains unlimited profit potential while limiting downside risk

Flexible delivery date of currency (can buy an option for a longer period than needed)

No obligation to buy or sell a currency

No premium payable

Profit and loss potential unlimited

Indefinite delivery date of currency rises, say one month after the trader has purchased the option, the trader could choose to sell the option back. By doing this, the trader will recoup both the time value and intrinsic value of the option.

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