currency option as hedging1 tool
TRANSCRIPT
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CURRENCY OPTION AS HEDGING
TOOL
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CURRENCY OPTION
Currency options are derivatives contracts in
which foreign currency is the underlying asset.
Currency options are also known as forex
options or Fx options. The contract is between
a buyer and a seller and gives the buyer the
right (but not the obligation) to buy or sell the
underlying foreign currency at a specifiedprice on an agreed upon date in the future
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Two types of currency option
Call option
Put option
The benefits of currency options are: hedging against the adverse movements of
exchange rate
only option contracts that are traded 24 hoursa day.
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How are Currency Options Traded?
Right to buyer but no obligation
the seller of the option is paid a price, known as
premium
strike price.
When an investor believes that US dollar will
appreciate against the Euro, he purchases a
currency call option on USD/EUR. If the value ofthe US dollar actually increases against the Euro,
the buyer can exercise his right to earn a profit.
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HEDGE
A hedge is a financial term denoting an
investment position intended to offset
potential losses that may be incurred by a
companion investment.
Hedge is the technique which supports to
protect or mitigate risk arise on account of
merchandise transactions with overseasmarket, and other currency involved.
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OPTION CONTRACT
An option contract is defined as "a promise
which meets the requirements for the
formation of a contract and limits the
promisor's power to revoke an offer
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TYPE OF CURRENCY OPTION
Put Option :
A currency Put option is an option but not an
obligation to sell currency during a specifiedtime period at a specified price.
Call Option :
A currency Call option is an option but not anobligation to buy currency during a specified
time period at a specified price.
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HOW TO CALCULATE OPTION
CONTRACT
E.G- You have to pay pound 1mn sep-1999.
And need to make sure that your T.C not more
than $1.60/GBP Say you can buy 32 Sep call contracts on the
pound at strike rate $1.58 paying a price 1.98
cent per pound
So 32*31,250 GBP= 1mn Pound
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Option Payoff Diagrams
Buy call: right to
purchase foreign
currency
Buy put: right to
sell foreign
currency
Profit
ForwardRate
+
0
_
BUYCALLOPTION
Strike
Premium
Profit
Forward
+
0
_
SELLCALLOPTION
Profit
Forward
+
0
_
BUYPUTOPTION
Profit
Forward
+
0
_
SELLPUTOPTION
Figure 2. Payoff at Expiration of Options. Eg. buying a call produces a gain if the currency (ie the futures price) rises
above the strike plus the premium; the call writer's profit profile is opposite.
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PARTIES TO OPTION
Buyers have option
Seller do not have option
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PUT CALL PARITY
putcall parity defines a relationship between
the price of a European call option and
European put option
C(t) P(t) = S(t) K *B(t,T)
C(t) P(t) + D(t) = S(t) K *B(t,T) (if Dividend)
Equivalence of calls and Put
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BINOMIAL MODEL
The binomial options pricing model (BOPM)
provides a generalizable numerical method for
the valuation of options
Option valuation using this method is, as
described, a three-step process:
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What is a Binomial Tree?
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Step 1: Constructing a Stock
Price Tree
T
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Step 2: Valuing the Option at
Time of Expiry
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How Do I Value the Option at
Earlier Nodes?
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Step 3: Valuing the Option
Through Backward Induction
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CONCLUSION
Many corporate risk managers attempt to construct hedgeson the basis of their outlook for interest rates, exchangerates or some other market factor. However, the besthedging decisions are made when risk managers
acknowledge that market movements are unpredictable. Ahedge should always seek to minimize risk. It should notrepresent a gamble on the direction of market prices. Awell-designed hedging program reduces both risks andcosts. Hedging frees up resources and allows managementto focus on the aspects of the business in which it has a
competitive advantage by minimizing the risks that are notcentral to the basic business. Ultimately, hedging increasesshareholder value by reducing the cost of capital andstabilizing earnings.