Currency options

A currency call (put) option is a contract that gives the owner the right, but not the obligation, to buy (sell) a currency at a specified price at (European) or during (American) a given time. OTC currency options are most frequently written by banks for US dollars and other currencies against the British Pound, Swiss Franc, Japanese Yen, Canadian Dollar and the Euro. The main advantage is that they are tailored to the purchaser, but counterparty risk exists. OTC currency options are mostly used by individuals and banks. Currency options are also traded on organised exchanges, such as Euronext N.V., with clearing facilities provided by the clearing-houses of these exchanges. Counterparty risk is not present in this case.

Comparison of derivative transactions in the currency market

The following trading (speculation) and hedging cases illustrate the alternative financial instruments that are available to market participants in the shipping industry, in order to hedge their forex rate exposures in the physical market.

Case 1: Alternative trading strategies

Assume that the financial manager of a shipping company has /100,000 and is willing to trade this money for investment purposes, based on her view of how currency rates will evolve, in the spot, the forward and in the options market. The financial manager (henceforth, trader) believes that the US dollar will appreciate in relation to the British pound in six months. The current January spot rate and six-month forward rates are //$0.5392 and /(/$0.5301, respectively. A call and a put option on dollars, with a strike price of //$0.5394, are available and sell at a premium of //$0,005 each. The alternative trading strategies are presented next.

Alternative 1: Money market trade

The trader uses the /100,000 to purchase $185,459.94 in January, at the spot rate of //$0.5392, and holds the dollars for six months. When the target exchange rate is reached, she sells the $185,459.94 at the new spot rate of //$0.5400, receiving /100,148.36 (= $185,459.94 x //$0.5400). This results in a profit of/148.36 (= /100,148.36 - /100,000).

Alternative 2: Currency forward trade

The trader uses the forward market, because he believes that the June spot rate will differ from the January forward rate of June. Therefore, during January he purchases $188,643.65 using the forward six-month rate of //$0.5301, with no initial cash outlay. Six months from now, in June, when the forward contract expires, he receives $188,643.65 at //$0.5301, at a cost of /100,000. He simultaneously sells $188,643.65 in the spot market at the prevailing spot rate of //$0.5400, receiving /101,867.57 (= $188,643.65 x //$0.5400). This results in a profit of/1,867.57 (= /101,867.57 — /100,000), with no initial investment required.

Alternative 3: Currency options trade 1

The trader during January buys a call option on dollars ($185,459.94), with a strike price of //$0.5394, at a premium of //$0,005. As spot rates (//$0.5392) are below the strike price, she is not exercising this option because she can purchase dollars cheaper in the spot market. Her loss is limited to the cost of the option; that is, to the premium of //$0,005. As June spot rates (//$0,540) become higher than the strike price (//$0.5394) it becomes worth exercising the option. Thus, she buys dollars at //SO.5394, which she can sell for //$0,540 in the spot market, making a gain of //$0.0044 {= Max[(spot rate — strike price), 0] — premium = Max[(//$0.5400 — //$0.5394), 0] — //$0,005}. This results in a profit of /816.02 (= SI85,459.94 x //$0.0044). The call option holder’s gain is the option writer’s loss and vice-versa. When the spot rate is below //$0.5394, the holder of the option is not exercising the option and the writer keeps the premium of //$0,005. As June spot rates (//$0.5400) are higher than the strike price of //$0.5394, the holder of the option exercises it and the writer has to pay the holder of the option. This results in a loss for the writer of /816.02 (= $185,459.94 x //$0.0044).

Table 11.6 Alternative trading strategies in the currency market

January

June

Panel A: Spot market

Forex rate: ,£/$0.5392 Investment amount: £100,000 Action: Purchase $185,459.94 (= £100,000 / £/$0.5392)

Forex rate: £/$0,540

Action: Sell $185,459.94 at £/$0,540

receiving £100,148.36

Outcome: Profit of £148.36 (= £100,148.36 - £100,000)

Panel B: Forward market

Forward six-month rate: £/$0.5301 Investment amount: £100,000 Action: Purchase $188,643.65 (= £100,000 / £/$0.5301)

Forex rate: £/$0.5400

Accept delivery of $188,643.65

Action: Sell $188,643.65 at £/$0,540 receiving

£101,867.57 (= $188,643.65 x £/$0,540)

Outcome: Profit of £1,867.57 (= £101,867.57 - £100,000)

Panel C: Options market (Case 1)

Options contract: June call option Call strike price: £/$0.5394 Options premium: £/$0,005 Action: Buy June call option

Spot Forex rate: £/$0,540

Strike price (£/$0.5394) < Spot price (£/$0,540)

Action: Exercise the call option

Options payoff: £/$0.0044

1= (£/$0.5400 - £/$0.5394) - £/$0.0051

Outcome: Profit (Loss) of £816.02 (= $185,459.94 x £/$0.0044) for the option call holder (writer)

Panel D: Options market (Case 2)

Options contract: June put option Put strike price: £/$0.5394 Options premium: £/$0,005 Action: Buy June put option

Spot Forex rate: £/$0,540

Strike price (£/$0.5394) < Spot price (£/$0,540)

Action: Put option is not exercised

Options payoff: —£/$ 0.005 (options premium)

Outcome: Loss (Profit) of £927.30 (= $185,459.94 x £/$ 0.005) for the put option holder (writer)

Alternative 4: Currency options trade 2

The trader duringjanuary buys a put option, to have the right to sell currency at the strike price of £/$0.5394, at a premium of £/$0,005. If the spot rate falls below £/$0.5394 he will exercise the option for a profit {= Max[(strike price — spot rate), 0] — premium}. As June spot rates (£/$0.5400) are higher than the strike price of £/$0.5394 he does not exercise the put option, as he is better off selling the currency spot. He loses the option premium of £/$0,005, with a position loss of£927.30 (= $185,459.94 x £/$0,005). His counterparty is the seller/writer of the put option. He is obliged to purchase dollars at the strike price of £/$0.5394 if the holder of the put decides to exercise, and he receives a premium of £/$0,005. If the spot rate falls below £/$0.5394 the holder will exercise the option and the writer of the put option will realise a loss, which is equal to — Max[(strike price — spot rate), 0] — premium. As June spot rates (£/$0.5400) are higher than the strike price of £/$0.5394, the put option is not exercised by the holder, as he is better off selling the currency spot. He loses the option premium of £/$0,005, with a position loss of £927.30 (= $185,459.94 x £/$0,005). This is the put option writers gain.

Table 11.7 presents the alternative trading strategies examined and their outcomes. From the four trading strategies shown, the currency forward contract yields the highest profit, of £1,867.57, with no initial investment. The trader, since she is seeking the highest profit-making strategy, should go for the currency forward contract. She should

Table 11.7 Alternative trading strategies and outcomes

Speculating strategy

Outcome (payout)

Remain unhedged

Uncertain

Spot market

Profit of £148.36

Currency forward market

Profit of £1,867.57

Currency call option

Profit of £816,02

Currency put option

Loss of £927.30

also keep in mind that if her expectations regarding the future movement of the currency market do not materialise, she can incur maximum losses, in comparison to the alternative strategies. This is not the case with options, whose downside risk is limited to the options’ premium.

 
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