Currency Options: Pricing and Strategies

FINC 456

Currency Options: Hedging Euros, yet again

Consider an exporter, who sells stuff in Europe and is expecting to receive 100,000,000 euros in 6 months.
Euro rates are 4% and U.S. rates are 2%, and spot is 1.25.

Risk here is that the Euro

Could sell the euros forward at 1.23756, and receive for sure $123,756,000 in six months. But what if manager expects the Euro to appreciate?

Could also protect against the risk by buying an option to sell euros at 1.23756.
Say that costs $40,000 for each 1,000,000 euros. Where does the exporter break even?

Currency Hedging: Forwards vs. Options

The forward contract gives a sure payoff in the future, but provides no room for appreciation of the currency to profit the exporter The option contract allows hedging while retaining profit potential, but incurs a cost that must be accounted for in calculating the breakeven.
In a very real sense, the profit potential given up in the forward contract pays for a lower breakeven value Well get back to this in a minuteright now, where did that $40,000 per 1,000,000 Euros come from?

Also, what does the payoff to the exporter look like?

Pricing Currency Options

Analogous to the case of forward contracts, currency options require only a small modification to our basic pricing formulas The first thing to remember though, is that currency options can get very confusing unless we lay down some rules: $ The spot rate (S) and strike price (X) are always in For
A call option is the right to buy FOR at X for $. A put option is the right to sell FOR at X for $.

The problem is that few currencies are quoted as $/FORso the answer is to always convert.

Pricing Currency Options Keeping it straight

The preceding rules ensure that call options get cheaper as X is set higher than S
Paying foreign currency in the future implies that you are exposed to an appreciation of the currency To hedge against currency appreciation, you buy the right to buy the currency at X > S
That is, you buy call options to buy FOR with $ at X, OTM.

Put options get cheaper as X is set lower than S

Receiving foreign currency in the future implies that you are exposed to a depreciation of the currency To hedge against currency depreciation, you buy the right to sell the currency at X < S.
That is, you buy put options to sell FOR with $ at X, OTM.

rf, the foreign interest rate

When we priced forwards on currency, we had to adjust the cost of carrying the asset
That is, the forward price was

To price currency options, the adjustment is exactly the same!

We replace the riskfree rate with rd-rf, and we need to discount the spot rate at the foreign interest rate
Why?

F0 = S 0 e

( r r f )T

This leads to the formula for pricing currency options in the Black-Scholes world:
Note: occasionally this is called the Garman-Kohlhagen formula, in what must be the easiest naming opportunity

The Black-Scholes Formula

The Black-Scholes (GK) formula is:

c = Se
r f T

N (d1 ) Xe rdT N (d 2 )
r f T 2

p = Xe rdT N ( d 2 ) Se d1 = d2 = ln S

( X )+ (r

N ( d1 ) 2

rf + rf

T 1 T Recall that the currency forward formula was:

ln S

( X )+ (r

T
2 d

)T

)T = d

F = S0e

( r r f )T

Options and Forwards: Pricing Relationships

If we know the forward price on the currency, the B-S formula simplifies to: c = e rd T [FN (d1 ) XN (d 2 )] ln F p = e rdT [ XN ( d 2 ) FN ( d1 )]

d1 =

T 2 ln F T X 2 = d T d2 = 1 T

( X )+ ( T 2 )
2

( ) (

Lets look at that again

Heres a question:
If a call and a put with similar strike prices on a currency cost the same amount, whats the strike price?

Currency Hedging Strategies

How would you hedge a payment in pesos in 1 year?

Say you have to pay 500,000,000 pesos for McDonalds franchises in Baja California The spot rate is 10 pesos/$, MXN rates are 8% and USD rates are 2%.

What is your risk? One idea: buy pesos forward at 10.6184 MXN/$.
This costs you $47,088,227 in a year.

Or perhaps you buy the right to buy pesos at .10 $/peso (thats 10 pesos/$)
Whats your maximum cost (At 11.5% volatility)?

Hedging Peso Payments

Well, if the option costs about $1,000,000, then the most that could be paid is about $51,000,000
Since I have the right to buy pesos at 10, and 500,000,000/10=$50,000,000, and then theres the option cost Might be interested in the rate where I do as well as the forward.
Currency Option Pricing
Paying Currency (buying call)

Inputs
Notional Amount

Hedging Prices
0.09418 10.61836547 0.00209 0.00780 $ $ $ $ 1,044,740 3,898,856 47,088,227 47,088,227

500,000,000 MXN Forward 0.1000 Spot Rate (USD/MXN) 10.000 Call (buy MXN) 0.1000 Strike Price (USD/MXN) 10.000 Put (sell MXN) 2.00% Riskfree Rate USD Cost to buy MXN Riskfree Rate MXN Volatility Maturity (days) Maturity (years) 8.00% 11.50% 365 1 Cost to sell MXN Cost at 10.859 Cost at forward

Hedging Peso Payments

Hedged Cost, Peso Payment
$52,000,000

$50,000,000

$48,000,000

$46,000,000

Cost F at Forward
$44,000,000

$42,000,000

$40,000,000
9 .0 9 .1 9 .2 9 .3 9 .4 9 .5 9 .6 9 .7 9 .8 9 .9 10 . 0 10 . 1 10 . 2 10 . 3 10 . 4 10 . 5 10 . 6 10 . 7 10 . 8 10 . 9 11. 0 11. 1 11. 2 11. 3 11. 4 11. 5

Another Currency Strategy

How could I reduce the cost of the option strategy?

Weve already seen one way to get it down to zero!

A classic strategy for hedging currency risk is called a range forward

The idea is to buy an option and sell an option such that there is zero net cost up front (just like a forward) The buyer can set a level of protection that he is comfortable with, and that determines the profit appreciation available to him

The more risk taken, the more profit potential:

In fact, the range forward is the most clear illustration of the trade-off between risk and return available with options Also a dramatic example of customizability

Range forward example in Euros

Reconsider the exporter who is receiving 100,000,000 Euros in 6 months.

Buy a forward at 1.23756 and lock in $123,756,000. Buy an option to sell euros at 1.23756 for $4,000,000
Here you breakeven only if the euro goes above 1.127-ish.

But you could also buy an option to sell euros at 1.2 and sell an option to buy euros at 1.279costs you nothing!
Worst case is that you receive 120 million, best case is that you get 127.9 million

Other pairs are: 1.22 and 1.257 or 1.15 and 1.336.

The more risk, the more profit!

Euro Range Forwards

Range Forward Example
Exchange Rate Domestic Int. Rate Foreign Int. Rate Volatility Term (in days) Strike Step Forward 1.25 2.00% 4.00% 12.00% 182.5 0.01 1.23756

Range Forward Curve

1.350 1.340 1.330 1.320 1.310 1.300 1.290 1.280 1.270 1.260 1.250 1.240 1.14

1.336 1.325 1.313 1.301 1.290 1.279 1.268 1.257 1.246

1.16 1.18 1.20 1.22 1.24

Call Strike

Put Strike Put Strike Call Strike Put Price Call Price $ $ 1.150 1.336 1.160 1.325 1.170 1.313 1.180 1.301 1.190 1.290 1.200 1.279 1.210 1.268 1.220 1.257 1.230 1.246 1.23756 1.23756 0.041 0.041 (0.00)

0.011 $ 0.013 $ 0.015 $ 0.018 $ 0.021 $ 0.025 $ 0.029 $ 0.033 $ 0.038 $ 0.011 $ 0.013 $ 0.015 $ 0.018 $ 0.021 $ 0.025 $ 0.029 $ 0.033 $ 0.038 $ 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

$ Cost on a million $ $ Cost on a million $

10,701 $ 12,881 $ 15,369 $ 18,187 $ 21,349 $ 24,869 $ 28,758 $ 33,022 $ 37,664 $ 41,427 10,701 $ 12,881 $ 15,369 $ 18,187 $ 21,349 $ 24,869 $ 28,758 $ 33,022 $ 37,664 $ 41,427

Currency Hedging Conclusions

Options add a near infinite degree of customizability to the hedging decision

Can tailor solutions directly to views and expectations Can also replicate the forwards we used before

Pricing currency options requires only some small changes to the Black-Scholes formulabut is tricky!
Need to ensure that spot rates are quoted consistently Need to be very clear about whether we are buying or selling the currency

Range forwards show dramatically the tradeoff between profit potential and risk (even in a forward!)