abhishreshthaa
Abhijeet S
Hedging with Currency Options:
Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while an inflow can be hedged by buying a put option. (Or writing a call option. This is a “covered call” strategy).
Options are particularly useful for hedging uncertain cash flows, i.e. Cash flows those are contingent on other events. Typical situations are:
a. International tenders: Foreign exchange inflows will materialise only if the bid is successful. If execution of the contract also involves purchase of materials, equipments, etc. from third countries, there are contingent foreign currency outflows too.
b. Foreign currency receivables with substantial default risk or political risk, e.g. the host government of a foreign subsidiary might suddenly impose restrictions on dividend repatriation.
c. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/bonds currently worth say DEM 50 million, which he is planning to liquidate in 6 months time. If he sells Dem 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM.
E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on September 1.
The market rates are as follows:
DEM/GBP Spot: 2.8175/85
90-day Swap points: 60/55
September calls with a strike of 2.82 (DEM/GBP) are available for a premium of 0.20p per DEM. Evaluating the forward hedge versus purchase of call options both with reference to an open position.
i. Open position: Suppose the firm decides to leave the payable unhedged. If at maturity the pound sterling/ DEM spot rate is St., the sterling value of the payable is (5,00,000) St.
ii. Forward hedge: If the firm buys DEM 5,00,000 forward at the offer rate of DEM 2.8130/PS or PS0.3557/ DEM, the value of the payable is PS (5,00,000 * 0.3557)=PS 1,77,850.
iii. A Call option: Instead the firm buys call options on DEM 5,00,000 for a total premium expense of PS 1000.
At maturity, its cash outflow will be
PS [(5,00,000)St +1025] for St<= 0.3546
and PS[5,00,000)(0.3546)+1025]
= PS 178325 for St>=0.3546.
Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%.
Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while an inflow can be hedged by buying a put option. (Or writing a call option. This is a “covered call” strategy).
Options are particularly useful for hedging uncertain cash flows, i.e. Cash flows those are contingent on other events. Typical situations are:
a. International tenders: Foreign exchange inflows will materialise only if the bid is successful. If execution of the contract also involves purchase of materials, equipments, etc. from third countries, there are contingent foreign currency outflows too.
b. Foreign currency receivables with substantial default risk or political risk, e.g. the host government of a foreign subsidiary might suddenly impose restrictions on dividend repatriation.
c. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/bonds currently worth say DEM 50 million, which he is planning to liquidate in 6 months time. If he sells Dem 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM.
E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on September 1.
The market rates are as follows:
DEM/GBP Spot: 2.8175/85
90-day Swap points: 60/55
September calls with a strike of 2.82 (DEM/GBP) are available for a premium of 0.20p per DEM. Evaluating the forward hedge versus purchase of call options both with reference to an open position.
i. Open position: Suppose the firm decides to leave the payable unhedged. If at maturity the pound sterling/ DEM spot rate is St., the sterling value of the payable is (5,00,000) St.
ii. Forward hedge: If the firm buys DEM 5,00,000 forward at the offer rate of DEM 2.8130/PS or PS0.3557/ DEM, the value of the payable is PS (5,00,000 * 0.3557)=PS 1,77,850.
iii. A Call option: Instead the firm buys call options on DEM 5,00,000 for a total premium expense of PS 1000.
At maturity, its cash outflow will be
PS [(5,00,000)St +1025] for St<= 0.3546
and PS[5,00,000)(0.3546)+1025]
= PS 178325 for St>=0.3546.
Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%.