A currency
option enables an enterprise to secure a desired exchange rate while retaining
the possibility of benefiting from a favorable evolution of exchange rate. Effective
exchange rate guaranteed through the use of options is a certain minimum rate
for exporters and a certain maximum rate for importers. Exchange rates can be
more profitable in case of their favorable evolution.
Apart from covering exchange rate risk, Options are also used for
speculation on the currency market.
Covering Receivables Denominated in Foreign Currency
In order to cover receivables,
generated from exports and denominated in foreign currency, the enterprise may
buy put option as illustrated in Examples
Example: The exporter
Vikrayee knows that he would receive US $ 5,00,000 in three months. He buys a
put option of three months maturity at a strike price of Rs 43.00/US $. Spot
rate is Rs 43.00/US $. Forward rate is also Rs 43.00/US $. Premium to be paid
is 2.5 per cent.
Show various
possibilities of how Option is going to be exercised.
Solution: The exporter
pays the premium immediately, that is, a sum of 0.025 x $ 5,00,000 x Rs 43.00 =
Rs 537,500. Now let us examine different possibilities that may occur at the
time of settlement of the receivables.
(a) The rate
becomes Rs 42/US $. That is, the US dollar has depreciated. In this situation,
put Option holder would like to make use of his Option and sell his dollars at
the strike price, Rs 43.00 per dollar. Thus, net receipts would be:
Rs 43 x $ 5,
00,000 - Rs 43.00 x 0.025 x $ 5,00,000
= Rs 43 x $ 5, 00,000 (1 - 0.025)
= Rs 41.925 x 5,
00,000
= Rs 2, 09,
62,500
If he had not
covered, he would have received Rs 42 x 5, 00,000 or Rs 21, 00,000. But he
would not be certain about the actual amount to be received until the date of
maturity.
(b) Dollar rate becomes Rs 43.50.
This means that dollar has appreciated a bit. In this case, the exporter does
not stand to gain anything by using his Option. He sells his dollars directly
in the market at the rate of Rs 43.50. Thus, the net amount that he receives
is:
Rs 43.50 x $ 5,
00,000 - Rs 43.00 x 0.025 x $ 5, 00,000
= Rs (43.50 -
43.00 x 0.025) x $ 5, 00,000
= Rs 42.425 x $
5, 00,000
= Rs 2, 12,
12,500
If he had not
covered, he would have got Rs 43.50 x $ 5, 00,000 or Rs 21,750,000.
(c) Dollar Rate,
on the date of settlement, becomes Rs 43.00, that is, equal to strike price. In
this case also, the exporter does not gain any advantage by using his option.
Thus, the net sum that he gets is:
Rs 43.00 x 5,
00, 000 - Rs 43 x 0.025 x 5, 00,000
= Rs (43 - 43 x
0.025) x 5, 00,000
= Rs 2, 09,
62,500
It is apparent
from the above calculations that irrespective of the evolution of the exchange
rate, the minimum amount that he is sure to get is Rs 2, 09, 62,500 and any
favourable evolution of exchange rate enables him to reap greater profit.
Covering
Payables Denominated in Foreign Currency
In order to cover payables denominated in a foreign currency, an
enterprise may buy a currency call Option. Examples illustrate the use of call
Option.
Example
An
importer, Vikrayee, is to pay one million US dollars in two months. He wants to
cover exchange risk with call Option. The data are as follows:
Spot rate, forward rate and strike
price are Rs 43.00 per dollar. The premium is 3 per cent. Discuss various
possibilities that may occur for the importer.
Solution: The importer
pays the premium amount immediately. That is, a sum of Rs 43 x 0.03 x 10,
00,000 or Rs 1,290,000 is paid as premium.
Let us examine
the following three possibilities.
(a) Spot rate on
the date of settlement becomes Rs 42.50. That is, there is slight depreciation
of US dollar. In such a situation, the importer does not exercise his Option
and buys US dollars from the market directly. The net amount that he pays is:
Rs
(42.50 x $ 10, 00,000 + 43 x 0.03 x $ 10, 00,000)
OR
Rs 4, 37, 90,000
(b) Spot rate,
on the settlement date, is Rs 43.75 per US dollar. Evidently, the US dollar has
appreciated. In this case, the importer exercises his Option. Thus, the net sum
that he pays is:
Rs 43 x $ 10, 00,000 + Rs 43 x
0.03 x $ 1, 00,000
OR
Rs43 x 1.03 x $ 10, 00,000
OR
Rs 4, 42, 90,000
(c) Spot rate,
on the settlement, is the same as the strike price. In such a situation, the importer
does not exercise Option, or rather; he is indifferent between exercise and
non-exercise of the Option. The net payment that he makes is:
Rs43 x 1.03 x $
10, 00,000
or
Rs 4, 42, 90,000
Thus, the maximum rate paid by the
importer is the exercise price plus the premium.
Example: An importer of
France has imported goods worth US $ 1 million from USA. He wants to cover
against the likely appreciation of dollars against Euro. The data are as
follows:
Spot rate: Euro 0.9903/US $
Strike price: Euro 0.99/US $
Premium: 3 per cent
Maturity: 3 months
What are the
operations involved?
Solution: While buying a
call Option, the importer pays upfront the premium amount of
$ 10, 00,000 x 0.03
Or
Euro 10, 00,000 x 0.03 x 0.9903
Or
Euro 29,709
Thus, the
importer has ensured that he would not have to pay more than
Euro 10, 00,000 x 0.99 + Euro
29709
Or
Euro 10, 19,709
On maturity,
following possibilities may occur:
Ä
US dollar appreciates to, say, Euro 1.0310. In
this case, the importer exercises his call Option and thus pays only Euro 10,
19,709 as calculated above.
Ä
US dollar depreciates to, say, Euro 0.9800. Here,
the importer abandons the call Option and buys US dollar from the market. His
net payment is Euro (0.9800 x 10, 00,000 + 29,709) or Euro 10, 09,709.
Ä
US dollar Remains at Euro 0.99. In this case, the
importer is indifferent. The sum paid by him is Euro 10, 19,709.
The payment
profile while using call Option is shown in Figure
Covering a Bid
for an Order of Merchandise
An
enterprise that has submitted a tender will like to cover itself against
unfavorable movement of currency rates between the time of submission of the
bid and its acceptance (in case it is through). If the enterprise does not cover,
it runs a risk of squeezing its profit margin, in case foreign currency undergoes
depreciation in the meantime.
However, if it covers on forward
market, and its offer is not accepted, in that eventuality, it will have to
sell the currency on the market, perhaps with a loss. Therefore, a better
solution in the case of submission of bid for future orders is to cover with
put options. The put Option enables the enterprise to cover against a decrease
in the value of currency on the one hand, and allows him to retain the
possibility of benefiting from the increase in the value of the currency on the
other.
Example:
A
company bids for a contract for a sum of 1 million US dollars. While the
period of response is 6 months, the current exchange rate is Rs 43.50 per US
dollar. Six month forward rate is Rs 44.50 per US dollar.
Premium for a
put option of 6 months maturity is 3 per cent with a strike price of Rs 43.50.
Discuss various possibilities of
losses/gains in case the enterprise decides to cover or not to cover.
Solution:
(a) If the
enterprise does not cover and the dollar rate decreases, the potential loss is
unlimited.
(b) If the
enterprise covers on forward market and if its bid is not accepted
and the dollar rate increases, its potential loss is unlimited, since the
enterprise will be required to deliver dollars to the bank after buying them at
a higher rate.
(c) If the
enterprise buys a put option, it pays the premium amount of Rs 0.03 x $
10,00,000 x 43.50 or Rs 13,05,000. Now, there may be two situations:
1. The bid is accepted and the rate on the date of acceptance is
Rs 42.00 per dollar, i.e. the US dollar has depreciated. In this case, the put
option is resold (exercised) with a gain of Rs (43.50 - 42.00) x $ 10, 00,000 or Rs 15, 00,000
After
deducting the premium amount, the net gain works out to be Rs 1, 95,000 (Rs 15,
00,000 -Rs 13, 05,000). And, future receipts are sold on forward market.
Other possibility is that the bid is accepted but the US dollar
has appreciated to Rs 44.00. In that case, the Option is abandoned. And, the
future receipts are sold on forward market.
2. The bid is not accepted
and the US dollar depreciates to Rs 42.00. In that case, the enterprise
exercises its put option and makes a net gain of Rs 1, 95,000.
In case the bid is not accepted and
US dollar appreciates, the enterprise simply abandons its Option and its loss
is equal to the premium amount paid.
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