INTRODUCTION

Exposure to movements in foreign exchange rates and currency market volatility can be an advantage, particularly to currency speculators. However, the hedger like for instance a corporate treasurer, is different from the speculator in that he is risk averse. His priority is to reduce or eliminate currency exposure. But in reality the attitude to forex risk among corporate treasurers is wide-ranging. While some regard any forex risk with alarm and hedge it as soon as it occurs, some hedge it actively. Others never use the forward forex market and regard all windfall profits or losses as "acts of God".

All corporate treasurers, hedging their forex exposures with forward contracts, are aware that forward contracts are the best hedging instruments for safeguarding against adverse rate movements. However, forward contracts only turn the risk upside down and lead to opportunity losses in the event of favourable market movements. As against forward contracts, currency options are flexible inasmuch as they not only provide you protection against adverse market movements but also allow you to benefit from favourable ones. This flexibility of currency options, however, carries a price tag with it in the form of option premium, which is usually payable upfront.

DEFINITION

An option is a unique financial instrument or contract that confers upon the holder or the buyer thereof, the right but not an obligation to buy or sell an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer can simply let the right lapse by not exercising it. On the other hand, if the option buyer chooses to exercise the right, the seller of the option has an obligation to perform the contract according to the terms agreed. 

The asset underlying a currency option can be a spot currency or a futures contract on a currency. An option on a spot currency gives the option buyer the right to buy or sell the said currency against another currency while an option on a currency futures contract gives the option buyer the right to establish a long or short position in the relevant currency futures contract. Options on spot currencies are commonly available in the interbank over-the-counter markets while those on currency futures are traded on exchanges like the Chicago Mercantile Exchange (CME) and the Singapore International Monetary Exchange (SIMEX).

We shall hereafter discuss options on spot currencies available in the interbank OTC market.

OPTIONS TERMINOLOGY

Call Option:

A call option gives the option buyer the right to buy one currency X against another Y at a stated price on or before a stated date.

Put Option:

A put option gives the option buyer the right to sell one currency X against another currency Y at a stated price on or before a stated date.

In foreign exchange transactions one currency is bought by selling another currency. Thus if we consider the EUR/USD currency pair, a call option on the euro is no different from a put option on the dollar. Similarly, a put option on the euro is nothing but a call option on the dollar.

Strike Price:

This is the price specified in the option contract at which the option buyer can buy or sell currency X against currency Y or for instance the euro against the dollar.

Maturity Date:

The date on which the option expires.

American Option:

A call or put option that can be exercised by the buyer on any business day up to and including the maturity date.

European Option:

A call or put option that can be exercised only on the maturity date.

Premium (Option Price or Option Value):

The upfront fee that option writer or seller charges the buyer for giving the latter the right inherent in the option. If the option lapses unexercised, the buyer loses this amount. This premium can be split into 2 parts: intrinsic value and time value.

Intrinsic value is the amount an option would be worth were it to be exercised immediately. For instance, if an American call option on EUR has a strike price of $0.85 and the current spot EUR/USD rate is say $0.88, the intrinsic value is $0.03 per euro. European options can be exercised only at maturity. Even so, they can have intrinsic value. European call options will have intrinsic value if the forward rate applicable for the maturity date exceeds the strike price.

An option with an intrinsic value is called an in-the-money option. An American/European option is said to be at-the-money if the strike price equals the spot price/maturity forward price. Lastly, American/European call options are said to be out-of-the-money if strike price exceeds the spot price/maturity forward price. American/European put options are said to be out-of-the-money if the strike price is less than the spot price/maturity forward price.

An option can have time value only if it has some time remaining to expiry. Time value depends on the chances of the option gaining in value before expiry. At-the-money and out-of-the-money options have no intrinsic value and can have only time value.

The time value of a currency option thus depends upon a number of factors such as the spot price, strike price, time to maturity, volatility of the market price, domestic interest rate and the foreign interest rate. 

Call Put Parity :

This is a very important relation. If you consider a call option and a put option on the same currency (pair) with the same maturity and strike price, the difference between the call premium and the put premium equals the forward rate minus the strike price. In an equation form:

C - P = F - X

Thus, when F, the forward rate equals X, the strike price; the call and put premiums are equal.

Pay-off profiles at maturity : For a call option, if the maturity spot (S) is equal to or less than the strike price (X), the pay-off is a loss equal to the upfront premium paid (C). On the other hand, if S is greater than X, the pay-off equals S - X - C. For a put option, if S is equal to or greater than X, the pay-off is minus P. And, if S is less than X, pay-off on a put option is X - S - P.

With the euro spot at 0.87, volatility at 13% and the 3-month dollar and euro interest rates at 6.8% and 4.98% p.a. respectively, the premium of a call as well as put option with at-the-money strike of 0.8740 is $0.0224 per euro. Let us now have a look at the maturity pay-off profile of these options: 

Let us now consider first how the total value of European euro call options varies with changes in the above variables and then see how these options can be used to hedge exchange risk.

I. Strike price.

An out-of-the-money option has no intrinsic value. Now the more an option is out-of-the-money, the less is the chance of its expiring in-the-money and consequently lower is its time value. On the other hand, the value of an in-the-money option comprises of both intrinsic value and time value. In this case, the more an option is in-the-money the more is its intrinsic value but the lower is its time value as greater is the chance of it losing value and hence of being exercised. Thus other things being equal, an at-the-money option has the maximum time value.

Example:

II. Maturity:

The longer the time to maturity, the greater is the chance that an option may from move from at-the-money or out-of-the-money to in-the-money. Hence, longer the maturity, higher the time value but the relationship is not linear. 

Example: 

Domestic interest rate = Foreign interest rate (assumed)

III. Volatility:

The greater the chances of the underlying currency moving higher or lower over the maturity of the option, the higher will be the premium. The statistical measure normally used to gauge the volatility of markets is the standard deviation, more correctly the standard deviation of daily percentage changes in the underlying price. Volatility describes the size of likely price variations around the trend rather than the trend itself. The figure is usually annualised to give a constant measure. For instance, annualised volatility of 20% means that the currency has a 68% chance of being up or down within a 20% band within one year. It is possible to convert this figure into a daily volatility measure by dividing the annualised volatility by the square root of the number of trading days in a year (sq. root of 250 = 15.8). For instance, with spot euro at 0.87 and volatility at 13%, there is a 68% probability that the spot rate will range between 0.8628 and 0.8772 in a one-day period. 

Volatility is a key variable in option pricing. For at-the-money options, the relationship is almost linear. 

Example:

Essentially, there are two ways of looking at volatility. The first is to calculate the standard deviation of a given series of spot prices. What the trader is trying to do here is to find a measure of historical volatility, which adequately explains how the market has been moving and, more significantly, will give a reasonable idea of how the market is likely to move in the future. Volatilities are however not constant and therefore a second method of measuring volatility is to look at the actual premiums of traded options and to calculate the implied volatility. Implied volatilities are available on Reuters, Bloomberg, Bridge or other similar monitors.

IV. Interest rate differentials:

The effect of interest rates on option premiums is the least obvious, and yet, particularly with currency options, it is one of the most important components of the premium. For stock or commodity options, higher the interest rate, higher is the call option premium. This is so because higher the interest rate, greater is the opportunity cost of funds, which have to be deployed to buy the concerned stocks or commodities. In currency options, the situation is complicated by the fact that there are two interest rates involved, the domestic interest rate and the foreign interest rate . In this case, since the euro is priced in terms of the dollar, the domestic interest rate is that for the dollar and the foreign interest rate is that for the euro. The premium of an euro call option will increase if the dollar interest rate rises or the euro interest rate falls because in either case the cost of holding euros increases.

Example:

We have seen earlier that with the dollar interest rate of 6.8% and given the euro interest rate of 4.98% and the spot rate of 0.8700, the 3-month forward rate is 0.8740 and hence the above strike price of 0.8740 is at-the-money. Right now, the euro is a premium because the dollar interest rate is higher than that of the euro interest rate. If the dollar interest rate falls, the forward rate will fall. Consequently, a call option with a strike price of 0.8740 will be more and more out-of-the-money and its premium falls. Conversely, the call premium rises if the dollar interest rate rises. A put option with a strike price of 0.8740 will however be more and more in-the-money as the dollar interest rate falls and hence the put premium rises.

Let us now see what happens if the euro interest rate varies while dollar interest rate stands at say 6.8% and other parameters such as spot rate, strike price and maturity remain the same.

Now you find that as the euro interest rate rises from 3% to 7%, the call premium falls and the put premium rises. This is because the forward rate falls progressively. As the euro rate moves from 3% to 4.98%, a call option with strike price of 0.8740 becomes less and less in-the-money. When the euro interest rises still further to 7%, the said call option now becomes more and more out-of-the-money. Consequently, the call premium falls. The converse is true for put options.

HEDGING WITH CURRENCY OPTIONS

The objective of including currency options in your hedging arsenal has obviously to be to get the best protection available at the least possible cost. This is easier said than done. However, a corporate with foreign currency payables say in euro could use the following decision tree as a guide:

Currency hedging decision tree.

Notes:

* : Place good-till-cancelled stoploss orders just in case the currency strengthens unexpectedly.

atm = at-the-money

ootm = out-of-the-money

What is important to bear in mind is that options should be considered as complementary to forwards and not used to the exclusion of forwards. Even so once a decision is taken to hedge with options, one has to decide on the strike price and the maturity based on the expected direction of the market, volatility and also interest rates if hikes or cuts are imminent.

Another area is to consider the use of range forwards and participating forwards as also exotic options such as knock-ins, knock-outs, etc. In these cases, the option buyer’s main goal is to reduce or totally avoid the upfront premium payable in the case of plain call or put options. However, it should be borne in mind that for reducing or avoiding the premium, the hedger gives up a part of the protection and /or benefit. In the case of knock-in options, he risks not having any protection at all if the if the price of the underlying doesn’t reach a specified trigger level. While in the case of knock-out options, the hedger risks losing the protection completely if a specified trigger level is traded even briefly.

Let us now examine how an euro call option would compare with a forward contract or an open position depending on our choice of strike price and the spot price at maturity.

Example:

For instance, say you buy ATM euro call option with strike price of 0.8740 to hedge a 3-month euro liability. You pay an upfront premium $0.0224 per euro. Ignoring the interest lost on the premium outlay, buying the euro call will be better than booking an outright forward contract at 0.8740 only if the spot rate at maturity is less than 0.8516. This is so because only in that case the spot rate at maturity plus the call premium will be less than today’s forward rate. On the other hand, if the purchase of the call option is to be better than keeping the liability unhedged, the spot rate at maturity will have to be higher than the strike price plus the premium. The important thing to note in this illustration is that the option will fare worse than both a forward contract as well as an unhedged liability if the spot rate at maturity falls between 0.8516 and 0.8964. 

From the above table, it is clear that you can reduce the premium payable by an option, which is more and more out-of-the-money. However, as we mentioned earlier, you have to give up more and more protection to get a larger and larger premium reduction. Far out-of-the-money options may often be ruled out by your costing levels or risk limits.

Now let us compare the maturity pay-off of each of the above 3 options for different spot rates at maturity. Please note if the spot rate at maturity is less than or equal to the strike price, the option is not exercised and you lose the entire premium. If the spot rate at maturity is greater than the strike price, the option is exercised and you begin to recover the premium paid. However, the net pay-off to you from any option is positive only when spot rate at maturity is greater than the corresponding strike price plus the premium. Let us see examine this through the following table:

Option A : Strike price 0.8740 and premium 0.0224

Option B : Strike price 0.8900 and premium 0.0155

Option C : Strike price 0.9100 and premium 0.0092

You can observe that Option A outperforms Option B when spot rate at maturity exceeds 0.8809. Option A outperforms Option C when maturity spot exceeds 0.8872. Finally, Option B outperforms Option C when maturity spot exceeds 0.8963. You can choose the appropriate option depending on your market view and the maximum premium that you are willing to pay.

You may well say that you want free or zero-cost protection or insurance at a given strike price. This is possible under RBI guidelines. There are two simple ways to achieve this by buying calls and selling puts or vice versa. The only restriction is that you can’t receive a net premium.

Range Forward:

Suppose you have an euro liability 3 months from now. Present spot rate is 0.87 and the forward rate is 0.8740. If you want to cap your cost at say 0.90 free of cost, you will have to accept a floor at 0.8480. This involves buying an out-of-the-money call option with a strike of 0.90 and selling an out-of-the-money put option with a strike of 0.8480. The premium received on the put exactly offsets the premium paid on the call. If the maturity spot is over 0.90, you exercise the call and pay only $0.90 per euro. If the maturity spot is less than 0.8480, the put sold by you gets exercised and you pay $0.8480 per euro. Thus, your windfall benefit is limited. Finally, if the maturity spot is anywhere from 0.8480 to 0.9000, you pay the prevailing spot rate.

Participating Forward :

If you are very bearish on the euro and don’t want to accept any floor but still want the same cap as an insurance, there is still a way out. However, you will have to "lock in" the cap rate for a part of the exposure by selling an in-the-money put option with the same strike as that of the call. With an out-of-the-money 3-month euro call @ 0.90 costing $0.0121 per euro and an in-the-money 3-month euro put @ 0.90 fetching $0.0380 per euro, the amount of the put option has to be 31.8% of the amount of the call option. You will see that for 31.8% of the call option amount, you have bought a call and sold a put with the same strike of 0.90. This is like a synthetic forward inasmuch as either the call will be exercised or the put will be exercised and you are committed to paying $0.90 for 31.8% of the call option amount. In consideration, you have a ‘free’ call option @ 0.90 for the balance 68.2% of the exposure so hedged.

Let us compare the effective cost under these 2 alternatives:

Knock-out and knock-in options :

These are together known as Barrier Options and have a conditionality clause built into them. For instance, knock-out options cease to exist when the spot rate moves in a certain direction and touches a specified trigger level while knock-in options come into existence only when the spot rate touches a specified trigger level. The main advantage of these options is their smaller up-front premia compared to plain vanilla options. The trigger level can be above or below the present spot rate. Options that get knocked out when the spot rate touches a higher trigger level are called Up-and-Out options while those that get knocked out when the spot rate hits a lower trigger level are called Down-and-Out options. Knock-in options are also either Up-and-In options or Down-and-In options. A simple - call or put - option is nothing but a knock-out option plus a knock-in option with the same strike and same trigger level.

If these options are used for risk management, you would normally buy options which get knocked-out when spot rate has moved and is expected to move in your favour or knocked in when the spot rate has moved against you and is threatening your risk limit. That is a call option will get knocked out when the spot rate falls to a lower trigger level or gets knocked in when the spot rate rises to a higher trigger level. If you expect a temporary adverse price movement followed by a major trend reversal in your favour, you could do the opposite, that is, buy a call option that gets knocked in when the spot rate falls to lower trigger level. In such cases, you will still have to guard against an earlier-than-expected trend reversal through good-till-cancelled stoploss orders.

There are many zero-cost exotic combinations of simple options and knock-outs or knock-ins. One such version is called Smart Forward. Essentially, this is an out-of-the-money synthetic forward contract which you can walk away from if the maturity spot is more favourable provided a pre-specified trigger level has not been traded at any time during the life of the option. For example, for a 3-month euro liability with spot at 0.87 and ATM strike of 0.8740, if you specify your cap or risk limit as say 0.90, the bank may tell you that the trigger for the zero-cost smart forward is say 0.85. What this means is that if the spot rate trades at 0.85 any time during the life of the option, you will be obliged to buy euros at 0.90 irrespective of the maturity spot. On the other hand, if the spot rate has never hit the trigger level, the smart forward is like a simple out-of-the-money option. Besides, the more out-of-the-money the strike price is, the further is the trigger from the current spot rate. A few words of caution would not be out of place at this juncture. The names given to this and other similar hedges are so alluring as to make you feel smart, enhanced and so on. So be it but beware of the risks and don’t let these exotic names lead you up the garden path. How would it look, if in the above case the maturity spot of the euro is say 0.80 and you have to buy at 0.90? In a lighter vein, one slip and a smart forward might look like a dumb backward!