Forward
contracts as well as futures contracts provide a hedge to firms against adverse
movements in exchange rates. This is the major advantage of such financial
instruments. However, at the same time, these contracts deprive firms of a
chance to avail the benefits that may accrue due to favourable movements in
foreign exchange rates. The reason for this is that the firm is under
obligation to buy or sell currencies at pre-determined rates. This limitation
of these contracts, perhaps, is the main reason for the genesis/emergence of
currency options in forex markets.
Currency option is a financial instrument
that provides its holder a right but no obligation to buy or sell a
pre-specified amount of a currency at a pre-determined rate in the future (on a
fixed maturity date/up to a certain period). While the buyer of an option wants
to avoid the risk of adverse changes in exchange rates, the seller of the
option is prepared to assume the risk. Options are of two types, namely, call
option and put option.
Call Option
In a call option the holder has the right to
buy/call a specific currency at a specific price on a specific maturity date or
within a specified period of time; however, the holder of the option is under
no obligation to buy the currency. Such an option is to be exercised only when
the actual price in the forex market, at the time of exercising option, is more
that the price specified in call option contract; to put it differently, the
holder of the option obviously will not use the call option in case the actual
currency price in the spot market, at the time of using option, turns out to be
lower than that specified in the call option contract.
Put Option
A put option confers the right but no
obligation to sell a specified amount of currency at a pre-fixed price on or up
to a specified date. Obviously, put options will be exercised when the actual
exchange rate on the date of maturity is lower than the rate specified in the
put-option contract.
It is very apparent from the above that the option contracts place
their holders in a very favourable/ privileged position for the following two
reasons: (i) they hedge foreign exchange risk of adverse movements in exchange
rates and (ii) they retain the advantage of the favourable movement of exchange
rates. Given the advantages of option contracts, the cost of currency option
(which is limited to the amount of premium; it may be absolute sum but normally
expressed as a percentage of the spot rate prevailing at the time of entering
into a contract) seems to be worth incurring. In contrast, the seller of the
option contract runs the risk of unlimited/substantial loss and the amount of
premium he receives is income to him. Evidently, between the buyer and seller
of call option contracts, the risk of a currency option seller is/seems to be relatively
much higher than that of a buyer of such an option.
In view of high potential risk to the sellers of these currency
options, option contracts are primarily dealt in the major currencies of the
world that are actively traded in the over-the-counter (OTC) market. All the
operations on the OTC option markets are carried out virtually round the clock.
The buyer of the option pays the option
price (referred to as premium) upfront
at the time of entering an option contract with the seller of the option (known
as the writer of the option). The
pre-determined price at which the buyer of the option (also called as the holder of the option) can exercise
his option to buy/sell currency is called the strike/exercise price. When the option can be exercised only
on the maturity date, it is called an European
option; in contrast, when the option can be exercised on any date upto
maturity, it is referred to as an American
option. An option is said to be in-money,
if its immediate exercise yields a positive value to its holder; in case
the strike price is equal to the spot price, the option is said to be at-money, when option has no positive
value, it is said out-of-money
Example An Indian
importer is required to pay British £ 2 million to a UK company in 4 months time.
To guard against the possible appreciation of the pound sterling, he buys an
option by paying 2 per cent premium on the current prices. The spot rate is Rs
77.50/£. The strike price is fixed at Rs 78.20/£.
The Indian importer will need £ 2 million in 4 months. In case,
the pound sterling appreciates against the rupee, the importer will have to
spend a greater amount on buying £ 2 million (in rupees). Therefore, he buys a
call option for the amount of £ 2 million. For this, he pays the premium upfront,
which is: £ 2 million x Rs 77.50 x 0.02 = Rs 3.1 million
Then the importer waits for 4 months. On the maturity date, his
action will depend on the exchange rate of the £ vis-Ã -vis the rupee. There are
three possibilities in this regard, namely £ appreciates, does not change and
depreciates.
POUND STERLING APPRECIATES If the pound sterling appreciates, say to
Rs 79/£, on the settlement date. Obviously, the importer will exercise his call
option and buy the required amount of pounds at the contract rate of Rs
78.20/£. The total sum paid by importer is: (£ 2 million x Rs 78.20) + Premium
already paid = Rs 156.4 million + Rs 3.1 million = Rs 159.5 million.
Þ
Pound Sterling
Exchange rate does not Change - This implies that the spot rate on the date of maturity is Rs 78.20/£.
Evidently, he is indifferent/netural as he has to spend the same amount of
Indian rupees whether he buys from the spot market or he executes call option
contract; the premium amount has already been paid by him. Therefore, the total
effective cash outflows in both the situations remain exactly identical at Rs
159.5 million, that is, [(£ 2 million x Rs 78.20) + Premium of Rs 3.1 million
already paid].
Þ
Pound Sterling
Depreciates - If the pound sterling depreciates and the actual spot rate is
Rs 77/£ on the settlement date, the importer will prefer to abandon call option
as it is economically cheaper to buy the required amount of pounds directly
from the exchange market. His total cash outflow will be lower at Rs 157.1
million, i.e., (£ 2 million x Rs 77) + Premium of Rs 3.1 million, already paid.
Thus, it is clear that the importer is not to pay more than Rs
159.5 million irrespective of the exchange rate of £ prevailing on the date of
maturity. But he benefits from the favourable movement of the pound. Evidently,
currency options are more ideally suited to hedge currency risks. Therefore,
options markets represent a significant volume of transactions and they are
developing at a fast pace.
Above all, there is an additional feature of currency options in
that they can be repurchased or sold before the date of maturity (in the case
of American type of options). The intrinsic value of an American call option is
given by the positive difference of spot rate and exercise price; in the case
of a European call option, the positive difference of the forward rate and
exercise price yields the intrinsic value.
Intrinsic value (American
option) = Spot rate -Exercise price
Intrinsic value (European
option) = Forward rate - Exercise price
Of course, the option expires when
it is either exercised or has attained maturity. Normally, it happens when the
spot rate/forward rate is lower than the exercise price; otherwise holders of
options will normally like to exercise their options if they carry positive
intrinsic value.
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