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# INTERNATIONNAL FINANCIAL MANAGEMENT

LESSON 29: HEDGING WITH CURRENCY OPTIONS
Lesson Objectives
2. Forward hedge If the fulfill buys DEM 5:00,000 forward at the offer rate of DEM2.8130/£ or £0.3557/ DEM, the value of the payable is £(5,00,000 x 0.3557) = £1,77,850. This is shown as a horizontal line in Figure 13.1. 3. A Call option. Instead the firm buys call options on DEM 5,00,000 for a total premium expense of £1000. At maturity, its cash outflow will be £[(5,00,060)ST + 1Q:f_] for ST::; 0.3546 and £[(5,00,OOO)(0.3546) + 1025] = £178325 for ST 0.3546 We have assumed here that the premium expense is financed by a 90-day borrowing at 10%. Figure 13.1 illustrates. Open position and forward hedge are equivalent if the maturity GBP/DEM spot rate equals the forward rate at the beginning, viz. 0.3557. If it is higher, the firm is better off with a forward Call option and open position are equivalent when (5,00,000) St = (0.3546) (500000) + 1025 i.e. when St = 0.3537. At higher values, call option is better. Call option and forward are equivalent when (5,00,000) St + 1025 = (0.3537)(500000) i.e. when ST = 0.3567. At lower values than this the option alternative is better because of its one-way privilege – the firm can buy DEM in the spot market letting the option lapse. Figure 13.2 shows gains/losses of forward and call relative to the open position. For forward, the relative gain is £ [(ST- 0.3537 )(5,00,000)], while for the call relative gain is -£1025 for ST< 0.3546 and £ [(5,00,000)(ST-0.35465) – 1025 ] for ST >=0.3546 The call option becomes attractive relative to an open position for values of ST beyond 0.3567. Relative to the forward hedge, the call option is better I if the DEM depreciates below 0.3537. The maximum gain from the forward hedge, relative to the call is (5,00,000)(0.3546) + 1025 – (0.3557)(5,00,000 = £475 whereas, if the DEM depreciates sharply, call option can result in substantial savings. For instance at ST = 0.3520, saving from the call over the forward is £825.

• Different kinds of currency options and their uses • Hedging with currency options • Internal hedging strategies like neeting, offsetting, leading •
and lagging. Speculation in foreign exchange and money markets

Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while -an inflow an be hedged by buying a put option.(Or writing a call option. This is a “covered call” strategy). Options are particularly useful for hedging uncertain cash flows, i.e. cash flows that are contingent on other events. Typical situations are: 1. International tenders: Foreign exchange inflows will materialise only if the bid is.’ successful. If execution of the” contract also involves purchase of materials, equipment, etc. from third coun-tries, there are contingent foreign currency outflows too. 2. Foreign currency receivables with substantial default risk or political risk-e.g. the host govern-ment of a foreign subsidiary” might suddenly impose restrictions on dividend repatriation; 3. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/ bonds currently worth say DEM 50 million, which he is planning to liquidate in six months time. If he sells DEM 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM. We will discuss a few more examples of the use of options. We will particularly focus on the com-parison of options with forward hedge both with reference to an open position.

• On June 1, a UK firm has a DEM 5,00,000 payable due on
September 1. The market rates are as follows: DEM/GBP Spot: 2.8175/85 90-day Swap points: 60/55

• September calls with a strike of 2.82 (DEM/GBP) are
available for a premium of O.20p per DEM. We will evaluate the forward hedge versus purchase of call options both with reference to an open position. 1. Open position Suppose the firm decides to leave the payable unheeded. If at maturity the £IDEM spot rate is ST’ the sterling value of the payable is (5,00,OdO)ST’ In figure 13.1 this appears as a straight line through the origin. -

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Call The firm would like to cover the potential exposure. Thus suppose its forecast of S T can be summarised as follows: ST 0. the forward hedge now has a’.20 and 0. If the contract is awarded.000. the original hedge is carried to maturity. the expected cost is lower by £475 with a standard deviation of’602.3567 0. call’ option should be the preferred choice because of its smaller expected cost and smaller variance.60.0.3590 Probability 0. The choice now depends upon the firm’s riskreturn preferences: In the appendix to this chapter we briefly present a more rigorous analysis of this choice. subjective probabilities to future values of the spot rate.60 0. If the contract is not awarded.3557 0. 1.46 per USD.028 per DEM. the contract will be offset by a 2-month forward purchase at the then ruling rate. Figure 13. But it thinks that there is a 30% chance of a very slurp depreciation of the DEM (possibly because it thinks that the Bundesbimk is shortly going-to cut interest rates to stimulate the economy) and a 10% chance of a very sharp appreciation. close out by selling put options. (Assume that the options are bought on an options exchange). A put option on DEM with a strike price of DEM 1. The firm unwinds the hedge by either purchasing DEM 5 million 60-days forward if the initial choice was a forward contract or by selling put options. If however. The expected cost with forward hedge. 2.3537 Loss(-) Fig 13. the firm gets the contract and does not get the contract we will evaluate the two alternatives.INTERNATIONNAL FINANCIAL MANAGEMENT Value of the payable Open position Call option Forward 0.338 © Copy Right: Rai University 117 . viz. the choice is not clear.46 (We are ignoring two-sided quotes.30 0.3546 relative to an open posi-tion is then higher by £540 and its standard deviation is 1279.6.3510 0. The outcome of the competitive tender bidding will be known one month from now and the equipment is t6 be supplied over two months following the award of contract with payment being made on completion of delivery.75. the probabilities-s are changed to 0.45 per \$ and maturity of 90 days is available for a premium of 2. Sell DEM 5 million 90-day forward at DEM 1. The contract is valued at DEM 5 million.2 Gain & Losses from Alternative Hedging Strategies Thus whether the firm should choose the call option strategy. It might do a probabilistic mean variance analysis to compare the forwardhedge with the call if it can assign.5. For an option. 11. Thus in the mean-variance framework.3537 S(T) 0.1. the management has decided that any cover obtained must be offset if the firm is not awarded the contract. Also. smaller expected cost-compared to the call option (-140 and 255_respectively) but a much larger variance. The firm must pay an up-front premium of \$1.20. Under each contingency.10 The firm wishes to evaluate the following two alternatives: 1.8 or \$0.3557 0. It does not make any substantive difference). The bid is unsuccessful. scenarios. In each case we will consider three exchange rate. 0 0. The current market rates are: DEM/\$ spot: 1. We consider the gain/loss from each choice under the following three exchange rate scenarios at the end of one month: The firm considers the most probable value of maturity spot to be equal to the current forward rate. • A US firm has bid for a contract to supply computers and Forward Gain(+) related equipment to a German buyer. Purchase a put option 4 .3567 0.3557 0.50 90-day forward: 1. If at the end of the month the bid is not successful. the forward hedge or leave the expo-sure unhedged depends upon the view it takes of future spot rate.