CALL OPTION

• The Call Option establishes a ceiling for the exchange rate, and the option can be used to hedge foreign currency outflows (potential payments) • If S>X (Where S is the Spot price and X is the exercise or Spot exchange rate) => Profit increases one-for-one with appreciation of the foreign currency. At (X+P) the holder of the option breaks even (ceiling price). Here P is the Premium. • If S<X => The call option will not be exercised, because the holder is better off buying the foreign currency in the spot market. The holder will have a negative profit reflecting the premium, P

Profit Profile for a Call Option

Profit/Loss

Payoff Region

X+P X -P

Exchange Rate

Put Option
• The Put Option establishes a floor for the exchange rate, and the option can be used to hedge foreign currency inflows • If S>X => The call option will not be exercised, because the holder is better off selling the foreign currency in the spot market. The holder will have a negative profit reflecting the premium, P If S<X => Profit increases one-for-one with depreciation of the foreign currency. At (X-P) the holder of the option breaks even (floor price)

PUT OPTION
Profit/Loss

Payoff Region

Exchange Rate X-P -P X

EXAMPLE: Call Option
• The holder of a call option expects the underlying currency to appreciate in value. • Consider 4 call options on the euro, with a strike price of 152 ($/€) and a premium of 0.94 (both cents per €). • The face amount of a euro option is €62,500. • The total premium is: $0.0094·4·€62,500=$2,350.

Call Option: Hypothetical PayOff

EXAMPLE: PUT OPTION
• The holder of a put option expects the underlying currency to depreciate in value. • Consider 8 put options on the euro with a strike of 150 ($/€) and a premium of 1.95 (both cents per €). • The face amount of a euro option is €62,500. • The total premium is: $0.0195·8·€62,500=$9,750.

Put Option: Hypothetical payoff Profit at a spot rate of 148.15
Payoff Profile
Break-Even

0 -$500

148.05

150

148.15

Spot Rate

-$9,750 Loss In-the-money At Out-of-the-money

Comparing Futures and Options
The value of a futures contract at maturity (date t+n) to purchase one unit of foreign currency will be:

Value

0

Zt,t+n

St+n

The value of the futures contract is zero at maturity if the spot rate at maturity is equal to the current futures rate.

Consider now the value of an option to purchase one unit of foreign currency at that same price (i.e. a ‘call option’ with a strike price X equal to Zt,t+n ):

Value

0

X

St+n

The value of the call option begins increasing when the exchange rate becomes larger than the exercise price - when the option becomes ‘in the money.’

But we’re missing something. While a futures contract has an expected return of zero, the value of the option looks like it is always positive…

Value

0

X

St+n

Hence, anyone taking the opposite side of the transaction (‘writing’ the option) will demand a premium (C) that makes the expected value zero once again:

Value

0

C

X

St+n

Regardless of the outcome, the option’s value is reduced everywhere by the certain payment of its premium.

The value of an option to sell one unit of foreign currency (a ‘put’ option) at a strike price equal to a corresponding futures contract price will have similar properties:

Value

0

X

St+n

The Straddle Strategy
• During highly volatile market conditions investors use a buying straddle strategy. • On the other side of the transaction, when they expect neither sharp rise nor sharp fall in the exchange rate, they use a selling straddle strategy. • it consists in buying (in the case of a volatile market) or selling (in the case of a stable market) both a call and a put option at the same strike price and for the same maturation date.

The Straddle Strategy

The Strangle Strategy
• It consists in buying or selling a call and a put option at different strike prices. • The strangle buying strategy has unlimited profit potential if the exchange rate moves enough in either direction. The value of a strangle option increases along with the volatility of the underlying currency.

The Strangle Strategy