## Example

Let's see how call options may be used to cover possible exchange losses on import orders denominated in foreign currencies. Assume that on February 1 an American firm has purchased a mainframe computer from a Swiss firm for SFr625,000; its payment must be made in Swiss francs on June 1. Let us further assume that the premium for a franc call option with a strike price of \$0.5000 and a June expiration date is 0.03 cents per franc. Because there are 62,500 units per franc option, the US firm will need 10 call options to buy SFr625,000. The current spot rate for francs is \$0.4900; the US company's bank believes that the spot rate by June 1 will rise to \$0.6000.

There are two alternatives available to the US company: do not hedge, or hedge in the options market. If the US company does not want to cover its open position, it would wait for 4 months, buy francs at the prevailing exchange rate in the spot market, and use these francs to pay for its imports. If the bank's forecast is accurate, the US company will spend \$375,000 to purchase SFr625,000 at the spot rate of \$0.6000.

The price of 10 franc call options is \$187.50 (0.03 cents x 10 options x 62,500 units per contract). If the US company decides to hedge its position in the options market, on June 1 it would exercise its right to buy SFr625,000 for \$312,500 (\$0.500 x SFr625,000). Consequently, the US firm would spend a total of \$312,687.50 (\$187.50 + \$312,500) to purchase SFr625,000. By doing so, the American firm would avoid the risk of a \$62,312.50 loss (\$375,000 - \$312,687.50). Still, if the future spot rate for francs remains below the strike price of \$0.5000, the US company can let its options expire and buy Swiss francs at the prevailing spot rate when it must pay for its imports. Here, the US firm would lose its option premium of \$187.50.

Speculating in the call options market Individuals may speculate with currency call options based on their expectations of exchange rate fluctuations for a particular currency. The purpose of speculation in the call options market is to make a profit from exchange rate movements by deliberately taking an uncovered position. If a speculator expects that the future spot rate of a currency will increase, he makes the following transactions: The speculator will (1) buy call options of the currency, (2) wait for a few months until the spot rate of the currency appreciates highly enough, (3) exercise his option by buying the currency at the strike price, and (4) then sell the currency at the prevailing spot rate. When a speculator buys and then exercises a call option, his profit (loss) is determined as follows:

profit (loss) = spot rate — (strike price + premium)

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