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.

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 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)
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 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

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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

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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)

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1 ¥ = Re 1 / 1.9516

.·. ¥ 23059 = ?

= (¥23059 / ¥) *(Re /1.9516)

=Re. 11,815.433