AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2b. Options - calculations 11 / 13

Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

vi) Currency options

A right to sell (put options) or buy (call options) a currency at the exercise price in the future

Rules:

  • If the movement in the exchange rate is favourable 

    - don't exercise the option
    - let it lapse

  • If the movement is adverse

    - exercise the option

Steps:

  1. Do I want call or put options?

    Will I buy (call options) or sell (put options) the BASE currency?

  2. Choose expiry

  3. Choose strike (exercise) price

  4. How many contracts?

  5. How much BASE currency do I receive (call options)/pay (put options)?

  6. Calculate Premium

  7. Amount not hedged

  8. Choose whether to exercise

Example - Put options- Extract from the June 13 exam

Kenduri Co is based in the UK. It will have to pay $2,400,000 in 3 months.

Spot rate US$/£1:
1.5938-1.5962

Hedging using Forward: £1,500,375 payment

Required

Advise Kenduri Co on, and recommend, an appropriate hedging strategy for the US$ cash flows it is due to pay in three month.

Currency options available to Kenduri Co

Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1

Exercise Call options
3-month expiry
Call options
6-month expiry
Put options
3-month expiry
Put options
6-month expiry
1.60 1.55 2.25 2.08 2.23

Solution

  1. Do I want call or put options?

    BASE currency is £.

    Kenduri Co will pay $2.4m in 3 months, therefore have to sell £ to buy $2.4m, therefore Kenduri Co would purchase Sterling three-month put options to protect itself against a strengthening US$ to £.

  2. Choose expiry

    Kenduri Co will choose Put 3-month expiry options, because it will pay $2.4m in 3 months.

  3. Choose strike (exercise) price

    Exercise price: $1•60/£1

    £ payment = 2,400,000/1•60 = £1,500,000

  4. How many contracts?

    £1,500,000 / £62,500 = 24 contracts

    24 put options purchased

  5. How much BASE currency do I pay (put options)?

    £ payment = 2,400,000/1•60 = 1,500,000

  6. Calculate Premium

    Premium payable = 24 x 0•0208 x 62,500 = US$31,200

    Premium in £ = 31,200/1•5938 = £19,576

    Note:
    Kenduri Co will pay the premium in US$31,200. Kenduri Co have to buy $ from the bank (the bank will "sell LOW" $, therefore the Spot rate US$1.5938  is used.

  7. Amount not hedged

    All amount is hedged (refer to step 4)

  8. Choose whether to exercise

    Total payments = £1,500,000 + £19,576 = £1,519,576

    £1,519,576 > £1,500,375 FWD, therefore use the Forward rate hedge.

Example- Call options - Extract from the June 11 exam

Casasophia Co, based in a European country that uses the Euro (€) is due to receive the final payment of US$20 million in four months.

Spot rate $ Per €1:
US$1·3585–US$1·3618

4-month forward $ Per €1:
US$1·3588–US$1·3623

Hedging using Forward contracts is €14,681,054.

Required

Advise Casasophia Co on, and recommend, an appropriate hedging strategy.

 Exercise price     Calls 2-month expiry Calls  5-month expiry Puts 2-month expiry Puts 5-month expiry
1.36 2.35 2.80 2.47 2.98

Solution

  1. Do I want call or put options?

    BASE currency is EUR.

    Casasophia Co will receive $20m in 4 months and then will convert them to EUR (buy EUR), therefore Casasophia Co would purchase Euro call options to protect itself against a weakening Dollar to the Euro.

  2. Choose expiry

    Casasophia Co will choose Call 5-month expiry options, because it will receive $20m in 4 months. The 2-month expiry is too short.

  3. Choose strike (exercise) price

    Exercise Price: $1•36/€1

    € receipts =$ 20,000,000/($1•36/€1) = €14,705,882

  4. How many contracts?

    €14,705,882 / €125,000 =  117•6 contracts

    117 call options purchased

  5. How much BASE currency do I receive?

    € receipts = 117 x €125,000 = €14,625,000

  6. Calculate Premium

    Premium payable = 117 x 0•0280 x 125,000 = US$409,500
    Premium in € = 409,500/1•3585 = €301,435

    Note:
    Casasophia Co will pay the premium in US$409,500. Casasophia Co have to buy $ from the bank (the bank will "sell LOW" $, therefore the Spot rate US$1·3585 is used.

  7. Amount not hedged

    Amount not hedged = US$20,000,000 – (117 x €125,000 x 1•36) = US$110,000

    Use forwards to hedge amount not hedged = US$110,000/1•3623 (the banks "buy high")= €80,746

  8. Choose whether to exercise

    Total receipts = 14,625,000 Receipt– 301,435 Premium + 80,746 FWD = €14,404,311

    €14,404,311 < €14,681,054 FWD contract, therefore choose badge using the forward contract.