Currency options, offered on the OTC market, allow their holders to hedge their open FX position in a way similar to using a stop order. There are two basic differences:DurationA client, who buys an option to hedge an open FX position, has the opportunity to keep the position open so long as he desires but not longer than the option’s expiry date. Unlike using an option, when a stop order is placed, the position is automatically closed once the indicated price is reached.Locking in a maximum lossAn investor, who buys an option, is aware of the maximum potential loss he could endure, which is the option’s premium.
Investor’s objective:
To secure a maximum level of potential loss
Strategy:
Buying an “out of the money” put option
The investor buys an “out of the money” put option with an exercise price equal to the price he would normally place a stop order at, plus the option’s premium. The strategy is used to secure a maximum level of loss while keeping the opportunity to profit from the spot FX position until the option’s expiry date.Using options to hedge foreign currency money flows More and more companies, large and small, have foreign-currency denominated sales and purchases. Very often companies settle their accounts in foreign currency and a delay in payment could turn a profitable deal into a losing one because of unfavorable exchange rate movements. It is important to figure out a way to hedge against an unfavorable exchange rate movement while keeping the opportunity to profit from a favorable one.The exporter...
Let’s consider the following example: The exporter receives an order from abroad in the amount of 200 000 BGN. It is arranged that the importer will pay for the goods in USD, a month from now; the exchange rate at the time the deal is concluded is 1.25 BGN per $1 and therefore the exporter will receive $160 000 irrespective of what the exchange rate is at that time. The exporter will make a profit if at the end of the one-month period the dollar appreciates as he will receive $160 000 which will be equal to more than 200 000 BGN at the time. Potential depreciation of the dollar would hurt the exporter’s profit. How could he possibly hedge against depreciation of the dollar?Solution – buying a one-month call option at the exchange rate of 0.6391 Euro per $1 (0.6391 EUR = 1.25 BGN) from Deltastock AD If in a month’s time the exchange rate drops below 1.25 BGN per $1, the holder of the option will exercise it and Deltastock will pay him the difference which would guarantee that the exporter receives the full amount of 200 000 BGN. The exporter could at the same time take advantage from a favorable movement of the exchange rate by not exercising the option (see the table below).
Exchange rate (BGN per $)
1.90
1.95
2.00
2.05
2.10
Payment received in BGN
200 000
200 000
200 000
205 000
210 000 The importer...
Consider the following example: the importer buys goods from abroad valued at 200 000 BGN. It is arranged that the importer will pay for the goods in dollars, a month from now; the exchange rate at the time the deal is concluded is 1.25 BGN per $1 and therefore the exporter will receive $160 000 irrespective of what the exchange rate is at that time. The importer will make profit if at the end of the one-month period the dollar depreciates as he will make a payment in the amount of $160 000 which will be less than 200 000 BGN at that time. Potential appreciation of the dollar would hurt the importer’s profit. How could he possibly hedge against appreciation of the dollar?Solution – buying a one-month put option at the exchange rate of 0.6391Euro per $1 (0.6391 EUR = 1.25 BGN) from Deltastock AD If in a month’s time the exchange rate rises above 1.25 BGN to per $1, the holder of the option will exercise it and Deltastock AD will pay him the difference which would guarantee that the goods cost him no more than 200 000 BGN. The importer could at the same time take advantage from a favorable movement of the exchange rate by not exercising the option (see the table below).
Currency exchange rate (BGN per USD)
1.90
1.95
2.00
2.05
2.10
Payment received in BGN
190 000
195 000
200 000
200 000
200 000 These examples apply to all exporters and importers who are involved in international transactions and use foreign currency.
Investor’s objective:
To secure a maximum level of potential loss
Strategy:
Buying an “out of the money” put option
The investor buys an “out of the money” put option with an exercise price equal to the price he would normally place a stop order at, plus the option’s premium. The strategy is used to secure a maximum level of loss while keeping the opportunity to profit from the spot FX position until the option’s expiry date.Using options to hedge foreign currency money flows More and more companies, large and small, have foreign-currency denominated sales and purchases. Very often companies settle their accounts in foreign currency and a delay in payment could turn a profitable deal into a losing one because of unfavorable exchange rate movements. It is important to figure out a way to hedge against an unfavorable exchange rate movement while keeping the opportunity to profit from a favorable one.The exporter...
Let’s consider the following example: The exporter receives an order from abroad in the amount of 200 000 BGN. It is arranged that the importer will pay for the goods in USD, a month from now; the exchange rate at the time the deal is concluded is 1.25 BGN per $1 and therefore the exporter will receive $160 000 irrespective of what the exchange rate is at that time. The exporter will make a profit if at the end of the one-month period the dollar appreciates as he will receive $160 000 which will be equal to more than 200 000 BGN at the time. Potential depreciation of the dollar would hurt the exporter’s profit. How could he possibly hedge against depreciation of the dollar?Solution – buying a one-month call option at the exchange rate of 0.6391 Euro per $1 (0.6391 EUR = 1.25 BGN) from Deltastock AD If in a month’s time the exchange rate drops below 1.25 BGN per $1, the holder of the option will exercise it and Deltastock will pay him the difference which would guarantee that the exporter receives the full amount of 200 000 BGN. The exporter could at the same time take advantage from a favorable movement of the exchange rate by not exercising the option (see the table below).
Exchange rate (BGN per $)
1.90
1.95
2.00
2.05
2.10
Payment received in BGN
200 000
200 000
200 000
205 000
210 000 The importer...
Consider the following example: the importer buys goods from abroad valued at 200 000 BGN. It is arranged that the importer will pay for the goods in dollars, a month from now; the exchange rate at the time the deal is concluded is 1.25 BGN per $1 and therefore the exporter will receive $160 000 irrespective of what the exchange rate is at that time. The importer will make profit if at the end of the one-month period the dollar depreciates as he will make a payment in the amount of $160 000 which will be less than 200 000 BGN at that time. Potential appreciation of the dollar would hurt the importer’s profit. How could he possibly hedge against appreciation of the dollar?Solution – buying a one-month put option at the exchange rate of 0.6391Euro per $1 (0.6391 EUR = 1.25 BGN) from Deltastock AD If in a month’s time the exchange rate rises above 1.25 BGN to per $1, the holder of the option will exercise it and Deltastock AD will pay him the difference which would guarantee that the goods cost him no more than 200 000 BGN. The importer could at the same time take advantage from a favorable movement of the exchange rate by not exercising the option (see the table below).
Currency exchange rate (BGN per USD)
1.90
1.95
2.00
2.05
2.10
Payment received in BGN
190 000
195 000
200 000
200 000
200 000 These examples apply to all exporters and importers who are involved in international transactions and use foreign currency.
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