currency options v

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DERIVATIVES

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Derivatives are financial contracts whichderive their values from the underlying assets

or securities like stock or a currency.They are important tools used by business for

speculation and hedging.

They are of four types:-

Forwards Futures

Options

Swaps

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Currency options

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Definition

A foreign exchange option is a contract forfuture delivery of a specific currency in exchangefor another, in which the holder of the option hasthe right to buy (or sell) the currency at an

agreed price.• A contract (agreement)• Giving a right to buy/ sell• A specific asset• At a specific price• Within a specific time period

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Types of options• Call option

– Right to buy a currency– Useful in an appreciating market

•Put option– Right to sell a currency– Useful in a depreciating market

• Call and put option may be of two types– European option: can be exercised only on

expiry date– American option: can be exercised any time

upto expiry date

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Options terminology

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EXERCISE/STRIKE PRICE: The price at whichoptions are exercised.

PREMIUM: The value or price of the option.

IN-THE-MONEY: Strike price is less thanspot price.

AT-THE-MONEY: Strike price is equal to spotprice.

OUT-OF-THE-MONEY: Strike price is greaterthan spot price.

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Parties to option

contracts• Purchaser/Holder ( trader)

– Has right to exercise (may exercise or

may not exercise)• Writer/ seller ( dealer or speculator)

– Has obligation to perform (when

purchaser exercises the right)

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Options market• Listed currency options market (organisedexchange)– Philadelphia stock exchange (1982)– Standardised contracts– Clearing house acts as counter party– Maturity is fixed – Friday preceding third Wednesday of

March, June, Sept., Dec.

• Over the counter options market–

Inter bank/ bank to customer dealings– Customised contracts

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Profit or loss on optionstrading: Call option buyer

• Firm buys 100,000 call options (Euro)

• Strike price – Rs.60.50: premium – Re.0.05

•

On maturity: if spot rate = Rs.60.65,option will be exercised

• Buyer’s gain= (S-X-C)*100,000

• If spot rate on maturity is below Rs.60.50,option will expire unexercised; loss is thepremium paid (Rs.5000)

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Profit or loss on optionstrading: put option buyer

• Firm buy 20,000 put options (USD)

• Strike price = Rs.45.40; premium – Re.0.03

•

On maturity: If spot price is Rs.45, optionwill be exercised.

• Buyer’s gain= (X-S-C)*20,000

• If spot price exceeds Rs.45.43, option willexpire; loss is limited to premium ofRe.0.03 per option

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WHO NEEDS

OPTIONS?• Useful for anyone who requires a gain

if the exchange rate goes one way,

but wants protection against loss ifthe rate goes the other way.

• For hedgers

•

For speculators

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Implications for managers

Changing currency values may:-create opportunities for firms, orexpose firms to risks.

Affect value of individual purchases andsales

Affect value of assets in differentcountries

Affect value of liabilities denominated indifferent currencies.These changing values affect theprofitability and values of firms.

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It is important that managersunderstand the potential to managethose challenges and opportunitieswith appropriate financial markettransactions.

Managers must adjust theirexposures to currency fluctuationswithout having to disrupt their

normal business operations.