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    Options Theory

    Uploaded by

    parvathysdeepu
    The document discusses options contracts, including call and put options. It defines key terms like strike price, expiration date, and premium. It then provides examples of how options could be used to hedge risk in export/import transactions when the seller/buyer fears currency fluctuations. Specifically, it shows that an importer paying in foreign currency could buy a call option to get the right to purchase foreign currency at a fixed strike price, while an exporter receiving payment in foreign currency could buy a put option to get the right to sell foreign currency at a fixed price. Finally, it works through a problem where an importer needs to pay Japanese yen and compares using options vs forwards to hedge the currency risk.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd

    Options Theory

    Uploaded by

    parvathysdeepu
    44 views6 pages
    The document discusses options contracts, including call and put options. It defines key terms like strike price, expiration date, and premium. It then provides examples of how options could be used to hedge risk in export/import transactions when the seller/buyer fears currency fluctuations. Specifically, it shows that an importer paying in foreign currency could buy a call option to get the right to purchase foreign currency at a fixed strike price, while an exporter receiving payment in foreign currency could buy a put option to get the right to sell foreign currency at a fixed price. Finally, it works through a problem where an importer needs to pay Japanese yen and compares using options vs forwards to hedge the currency risk.

    Original Description:

    International Financial Management option theory notes

    Original Title

    Options theory

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    The document discusses options contracts, including call and put options. It defines key terms like strike price, expiration date, and premium. It then provides examples of how options could be used to hedge risk in export/import transactions when the seller/buyer fears currency fluctuations. Specifically, it shows that an importer paying in foreign currency could buy a call option to get the right to purchase foreign currency at a fixed strike price, while an exporter receiving payment in foreign currency could buy a put option to get the right to sell foreign currency at a fixed price. Finally, it works through a problem where an importer needs to pay Japanese yen and compares using options vs forwards to hedge the currency risk.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    44 views6 pages

    Options Theory

    Uploaded by

    parvathysdeepu
    The document discusses options contracts, including call and put options. It defines key terms like strike price, expiration date, and premium. It then provides examples of how options could be used to hedge risk in export/import transactions when the seller/buyer fears currency fluctuations. Specifically, it shows that an importer paying in foreign currency could buy a call option to get the right to purchase foreign currency at a fixed strike price, while an exporter receiving payment in foreign currency could buy a put option to get the right to sell foreign currency at a fixed price. Finally, it works through a problem where an importer needs to pay Japanese yen and compares using options vs forwards to hedge the currency risk.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 6

    OPTIONS

    Options: is a contract in which the seller of the contract grants the buyer, the
    right to purchase (or sell) from the seller ( or to the seller ) a designated instrument
    or an asset at a specific price which is agreed upon at the time of entering into the
    contract.

    Call option:

    Where the seller (or writer) gives the buyer of the option the right to purchase
    from him the underlying asset.

    Put option:

    Where the seller (or writer) gives the buyer of the option the right to sell to him
    the underlying asset.

    Exercise date:

    The date at which the contract matures.

    Strike price:

    At the time of entering into contract the parties agree upon a price at which the
    underlying asset may be bought (or) sold.

    Expiration period:

    The period (not more than 9 months from the date of introduction of the contract)
    during which the option can be exercised in the exchange (or) trade.

    Option premium:

    Is the amount which the buyer of the option (call or put) has to pay to the
    option writer to induce him to accept the risk associated with the contract.

    1
    Option matrix

    Buyer Writer or seller


    Call option Has the right to buy the Has an obligation to sell
    underlying asset the underlying asset.
    Put Option Has the right to sell the Has an obligation to buy
    underlying asset the underlying asset.

    Call Option buyer will exercise the option if

    Market Price on the Exercise or Expiration date > Strike price

    Put Option buyer will exercise the option if

    Market Price on the Exercise or Expiration date < Strike price

    IN THE CASE OF RECEIVABLE- EXPORT TRANSACTIONS

    a) If domestic currency option is available for example, 1Re =$ XXX

    Concept: The exporter fears the domestic currency appreciation (or) foreign
    currency depreciation. So he has to protect from such consequence to lock it
    buying domestic currency at a fixed rate say at strike price.

    So alternatives available are

    i. Buy call option ( have the right to buy the underlying asset)(or)
    ii. Write put option ( have the obligation to buy the underlying asset) in
    the case of (i) will pay premium (ii) will receive premium

    b) If foreign currency option is available for ex: 1$ = Rs.

    Concept: The exporter fears the domestic currency appreciation or foreign


    currency depreciation. So he has to protect from such consequence to lock it by
    selling foreign currency at fixed rate say at strike price.

    So available alternatives are

    i. Buy put option ( have the right to sell the underlying asset ) (or)
    2
    ii. Write call option ( have the obligation to sell the underlying asset)

    in the case of (i) has to pay premium in the case of (ii) has to receive
    premium.

    IN THE CASE OF PAYABLES – IMPORT TRANSACTIONS

    a) If foreign currency options are available. For example 1$=Rs.xxx

    Concept: Here the importer fears that foreign currency may appreciate and may
    domestic currency depreciate. Hence he will land up in paying higher amount than
    expected hence, he has to protect himself from such risk, will enter into buying the
    foreign currency at fixed rate say at strike price.

    i. Buy call options ( have the right to buy the underlying asset) (or)
    ii. Write put options ( have the obligation to buy the underlying asset)
    in the case of (a) will pay premium in case (b) will receive premium.

    b) If domestic currency options are available.

    Concept: Here the importer fears that the foreign currency may appreciate and
    domestic currency ma y depreciate. So, he will land up in paying higher
    amount than expected hence, he has to protect himself from such risk will enter
    into selling the domestic currency at fixed rate say at strike price.

    Buy domestic currency put option ( have the right to sell the underlying
    asset) (or)

    a. Write domestic currency call option( have the obligation to sell the
    underlying asset)
    in case (a) will pay premium in case (b) will receive premium

    3
    PROBLEM-01

    XYZ, an Indian firm, will need to pay JAPANESE YEN (JPY) 5,00,000 on
    30th June. In order to hedge the risk involved in foreign currency transaction,
    the firm is considering two alternative methods i.e. forward market cover
    and currency option contract.
    On 1st April, following quotations (JPY / INR) are made available:
    Spot 3months forward
    1.9516 / 1.9711 1.9726 / 1.9923
    The price for forex currency option on purchase are as follows:
    Strike Price JPY 2.125
    Call option (June) JPY 0.047
    Put option (June) JPY 0.098

    For excess or balance of JPY covered, the firm would use forward rate as future
    spot rate. You are required to recommend cheaper hedging alternative for XYZ.

    ANSWER

    XYZ an Indian firm, have payables in Japanese yen ¥ 5,00,000 on 30th June

    ALTERNATIVE I

    If payables covered through forward on 1st April

    Three months forward

    1Re = ¥ 1.9726 /1.9923

    .·.1 ¥=(Re / 1.19923) /(Re /1.9726)

    1 ¥ = Re /1.9726 (since payables three months forward ask rate is considered)

    ¥5,00,000 =?

    (Re /1.9726) * ( ¥ 5,00,000/ ¥) =Rs.2,53,473

    4
    ALTERNATIVE II

    Covered through option

    Concept: payables – the firm has to

    Purchase yen-

    If Re option is available in the market (domestic currency option is available) the


    firm has to sell Re to purchase ¥, for that it has to either buy a put option or write a
    call option. Since the firm has commitment to pay hence, it will always try to hold
    the right, so it will enter into buying a put option.

    Strike price 1 Re = ¥ 2.125, premium payable

    1Re = ¥ 0.098

    Since contract size is not given we consider the entire payable as one contract.

    1Re = ¥ 2.125

    ? = ¥ 5,00,000

    .·. At the time of exercising the put option we assume here that the market price is
    lower than strike price, so the firm will exercise put option.

    .·. Re out flow (¥ 5,00,000* Re1)/ ¥ 2.125 = Rs. 2,35,294

    + premium payable WN Rs. 11,815

    Total payables under option Rs.2,47,109

    Working note 1Re = ¥ 0.098

    For Re 2,35,294 = ?

    (¥ 0.098 * Re 2,35,294 ) /Re = ¥23059

    This ¥ 23059 has to be purchased spot at spot ask rate Re/1.9516

    Spot rate 1Re = (¥1.9516) /(1.9711)

    .·. 1 ¥ =( Re/ 1.9911) /( Re/1.9516)

    5
    1 ¥ = Re 1 / 1.9516

    .·. ¥ 23059 = ?

    = (¥23059 / ¥) *(Re /1.9516)

    =Re. 11,815.433

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