# FOREIGN EXCHANGE OPTIONS

Options are simple instruments for hedging. An option to sell the foreign currency and buy home currency at a preset exchange rate 0.82 €/\$, cost has a premium 0.02 €/\$ and maturity set at inception. If the foreign currency appreciates, the option is out-of-the-money and is worthless, but we get the upside of foreign currency above 0.82 €/\$. If the foreign currency depreciates, the option is in-the-money, and we get the preset exchange rate 0.82 €/\$. The premium, 0.02 €/\$ should be deducted from such gross payoffs.

A foreign exchange "collar" would serve as lower premium optional hedge. A collar consists of buying a put and selling a call at different strikes. Consider the seller of USD (foreign currency) against EUR (home currency). The seller would like to buy a put, or right to sell the USD at a preset price. The put strike is 0.82 EUR/USD. In order to reduce the cost of the put (right to sell the foreign currency), he/she sells a call to the bank (an option to buy a foreign currency at a preset exchange rate set to 0.90 EUR/USD). The sale generates revenue reducing his/her cost.

Below 0.82, the protection of the put applies. However, above 0.90, the buyer of the call buys the dollars at 0.90€/\$ even though they are worth more. The seller of the call cannot sell USD at more than 0.90 EUR/USD since he has contracted to sell at this exchange rate with the buyer of the call. The combined two options make up a collar providing a downside protection and a limited upside gain.

# HEDGING A CORPORATE LONG EXPOSURE IN FOREIGN CURRENCY (CASE STUDY)

The usage of hedging instruments for corporations is straightforward. An exporter expects a cash inflow of 1 million USD in six months. The exporter has a long position in the USD. The exporter fears a decline of the USD versus the Euro. The current spot exchange rate is 0.80 EUR/USD. Various choices are open for hedging this long exposure against a depreciation of the USD in terms of Euro.

• Doing nothing.

• Selling forward USD at the current forward rate, assumed to be 0.81 EUR/USD.

• Buying a put option: The option provides the right to sell USD against Euros, with a premium of 0.02 EUR/USD, with strike 0.82 EUR/USD.

The put option allows taking advantage of the upside of the USD whereas the forward contract is an obligation to sell forthcoming USD at the forward exchange rate. Payoff graphs are very convenient for comparing the three solutions. The spot (unknown exchange rate) at the time of the USD inflow is along the x-axis. The payoff is in EUR/USD on the vertical axis. (See Figure 8.3.)

Doing nothing means that the exporter will use the prevailing exchange rate, whatever it is. The payoff is the first diagonal, where the future exchange rate is equal to the prevailing spot rate at the future date. The forward contract payoff is a horizontal line with a constant payoff

FIGURE 8.3 Comparing foreign exchange hedges

of 0.81. The put option payoff is a kinked line. When the USD hits the strike 0.82, the payoff is the strike minus the premium paid, or 0.82 - 0.02 — 0.80 EUR/USD. When the exchange rate becomes higher than the strike, the option is out-of-the-money and the exchange rate is the spot exchange rate minus the premium paid upfront 0.02. The payoff is shown as a straight line parallel to the first diagonal but lower by 0.02.

As usual, one can consider both break-even values, such that no hedging is equivalent to hedging, and compare those with expectations. If expectations are such that a decline of the value of USD is likely, the best hedge is the one with the higher break-even point, which is the forward contract. No hedge at all is best when expectations are that the USD appreciates. Under a myopic view of the market, with no consensus at all on the direction, most corporations would opt for the forward because they know, at least, how to set up their budgets.

# THE FOREIGN EXCHANGE MARKET AND RATES

Foreign exchange rates fluctuate according to some macroeconomic drivers and expectations. The excess/deficit of the exports/imports of one country influence foreign exchange rates because trade unbalances generate symmetric unbalances between purchases and sales of the currency. Interest rate differentials between countries also influence foreign exchange because they make investing in one country relatively more or less attractive. Expectations about prospective exchange rates also drive the rates. An expected depreciation of a currency is an incentive to sell it before it depreciates, and, conversely, an expected appreciation is an incentive to purchase the currency at a cheaper rate today. In both cases, expectations tend to be confirmed by the actions they trigger (self-fulfilling prophecy).