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Hedging with Currency Options

Hedging with Currency Options. An American firm has 1,000,000 € payables 3months hence. Today the market rates are: Spot : 1.3825/1.3830; 90day forward swap points: 20/15; 90day $ denominated call options: Premium (p) = 29.50 Strike Price (X) = 138.55.

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Hedging with Currency Options

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  1. Hedging with Currency Options An American firm has 1,000,000 € payables 3months hence. Today the market rates are: Spot : 1.3825/1.3830; 90day forward swap points: 20/15; 90day $ denominated call options: Premium (p) = 29.50 Strike Price (X) = 138.55

  2. Before going into details of the case study we should be careful about the interpretation of the quotations of options. • In options market premium and strike price for dollar denominated contracts are given in cents: • So in our problem Premium(p) = 29.50 cents i.e. = 0.2950$/100€ Strike Price (X) = 138.55 cents i.e. = 1.3855 $/€

  3. The American firm has three alternatives to deal with the foreign exchange exposure: Open Position; Forward Hedge; Option Hedge;

  4. At maturity, assuming spot rate as ST ,under different • alternatives the outflow will be: • Open Position : 1,000,000 ST • Forward Hedge: Forward Rate : 1.3830 – 0.0015 = 1.3815 Outflow = 1,000,000 * 1.3815 = $1,381,500

  5. iii) Options Hedging: Case 1: If ST > X Premium : One contract in € involves 10000. So to purchase 1,000,000 €, 100contracts are needed. Premium for 1 contract = 10000 * 0.2950/100 = 29.5$ So for 100 contracts = 100 * 29.5 = 2950$

  6. Premium is paid at Upfront. But Exercising the option may be done after 90days. So assuming 10%p.a interest for 90 days the maturity value of this premium will be: 2950 + 2950 * 90/365 * 10/100 = 3023$(apprx) At maturity two cases may happen: Case 1: If ST > X Case 1: If ST < X

  7. Under Case 1, Option will be exercised and the outflow in Options hedging will be : 1,000,000 * 1.3855 + 3023 = 1,388,523$ Under Case 2, Option will not be exercised and the outflow in Options hedging will be : 1,000,000ST + 3023 in $

  8. So at maturity assuming spot rate ST the outflows under different alternatives are: Open Position : $1,000,000 ST Forward Position : 1,000,000 x 1.3815 = $1,381,500 Option Position: 1,000,000*1.3855 + 3023 = $1,388,523 (if ST>X) or 1,000,000ST + 3023 (if ST<X)

  9. Break Even Point between different alternatives: Break even point between any two alternative is that point where outflow is same i) Open position and Forward position: $1,000,000 ST = $1,381,500 So these two positions are equivalent when ST becomes equal to forward rate determined at time t = 0, here 1.3815 €/$. If ST> 1.3815, the forward hedging will be preferable.

  10. ii) Open position & Option position $1,000,000 ST = 1,000,000*1.3855 + 3023 So ST = 1.3885 As long as ST < 1.3885 open position will be Preferable; As soon as ST > 1.3885, Option will be exercised and it will be preferable

  11. iii) Forward position & Option position 1,000,000*1.3815 = 1,000,000ST + 3023 So ST = 1.3785 At lower spot value at maturity than this option is preferable than forward, because of its one way privilege-the firm can buy euro in open market letting the option lapse.

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