An Introduction to the Derivative Instruments

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Put options. A put gives the buyer the right, but not the obligation, to sell a specific amount
of an underlying at a predetermined price on or before a specific future date.
The buyer of the option has to pay a premium to the seller. Usually the premium is paid two or
three (depending on the underlying) business days after the option is agreed. The underlying
can be any financial asset (e.g., a security, a currency, a commodity) or a financial index (e.g.,
a stock market index, an interest rate).
2.4.2 Standard Foreign Exchange Options
Most FX instruments involve two currencies: a specific amount of one currency is delivered
(or sold) in exchange for receiving (or paying) a specific amount of another currency. An
interesting aspect of FX options is that they are simultaneously a call and a put option. If the
option is a call on one of the two currencies, it necessarily is a put option on the other currency.
Accordingly, when entering into a FX option, the term call (or put) is accompanied by the
currency for which the option is a call (or a put). For example, a USD/EUR option in which
the option buyer benefits if the USD strengthens is simultaneously a USD call and a EUR put
option. Likewise, a USD/EUR option in which the option buyer benefits if the USD weakens
is simultaneously a USD put and a EUR call option.
As a first example, suppose that a European entity highly expects to sell a plant to a US
customer. The plant is expected to be sold for USD 100 million in one year. The entity is
exposed to a declining USD relative to the EUR. Accordingly, the entity decides to hedge the
FX risk arising from the highly expected purchase by buying an option with the following
characteristics:
EUR Call/USD Put Terms
Buyer:
Option type:
Expiry:
Notional:
Strike:
Settlement:
Premium:

European entity
EUR Call/USD Put
One year
USD 100 million
1.16
Cash settlement
EUR 1.8 million to be paid two business days
after start date

As this option is cash settled, the option will pay a EUR amount at expiry only if the option
ends up being in-the-money. The cash settlement amount (i.e., the option payoff) at expiry is
calculated using the following formula:

EUR settlement amount = Maximum {USD Notional * [1/1.16 1/(FX rate at expiry)], 0}

Figure 2.8 shows the option payoff (i.e., the settlement amount) as a function of the
USD/EUR spot rate at expiry, without taking into account the premium that the entity paid for
the option.