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International Financial Management

P G Apte

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Introduction
• An option is a contract in which the buyer of
the option has the right to buy or sell a
specified quantity of an asset, at a pre-specified
price, on or upto a specified date if he chooses
to do so; however, there is no obligation for him
to do so
• Options are available on a large variety of
underlying assets including common stock,
currencies, debt instruments, and commodities.
• Options are also available on financial prices
such as interest rates

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Options on Spot, Options of Futures
and Futures Style Options
• Option on spot currency: Right to buy or sell
the underlying currency at a specified price; no
obligation
• Option on currency futures: right to establish a
long or a short position in a currency futures
contract at a specified price; no obligation
• Futures-style options: Represent a bet on the
price of an option on spot foreign exchange.
Margin payments and mark-to-market as in
futures.
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Options Terminology
• The two parties to an option contract are the
option buyer and the option seller also called
option writer
• Call Option: A call option gives the option
buyer the right to purchase a currency Y
against a currency X at a stated price Y/X, on
or before a stated date.
• Put Option: A put option gives the option buyer
the right to sell a currency Y against a currency
X at a specified price on or before a specified
date

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Options Terminology (contd.)
• Strike Price (also called Exercise Price) The
price specified in the option contract at which
the option buyer can purchase the currency
(call) or sell the currency (put) Y against X.
Maturity Date: The date on which the option
contract expires. Exchange traded options have
standardized maturity dates.
• American Option: An option, that can be
exercised by the buyer on any business day
from trade date to expiry date.
• European Option: An option that can be
exercised only on the expiry date
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Options Terminology
• Option Premium (Option Price, Option Value):
The fee that the option buyer must pay the
option writer “up-front”. Non-refundable.
• Intrinsic Value of the Option: The intrinsic
value of an option is the gain to the holder on
immediate exercise. Strictly applies only to
American options.
• Time Value of the Option: The difference
between the value of an option at any time and
its intrinsic value at that time is called the time
value of the option.

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Options Terminology
• A call option is said to be at-the-money if
Current Spot Price (St ) = Strike Price (X),
• in-the-money if St > X and out-of-the-money if
St < X
• A put option is said to be at-the-money if
• St = X, in-the-money if St < X and out-of-the-
money if St > X
• In the money options have positive intrinsic
value; at-the-money and out-of-the money
options have zero intrinsic value.

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Price Quotations
• Option Price Quotations (exchange traded)
GBP/USD GBP 31250 (cents per pound)
Strike Price CALLS PUTS
Sep Oct Nov Sep Oct Nov

1.490 2.26 2.80 -- 0.80 1.32 --


1.500 1.61 2.27 2.72 1.19 1.74 2.18
1.510 1.16 1.77 2.26 1.70 2.24 2.63

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Elementary Option Strategies
• Assumptions
– Ignore brokerage commissions, margins etc
– Dealing with European options
– All exchange rates, strike prices, and
premiums will be in terms of home currency
per unit of some currency A and the option
will be assumed to be on one unit of the
currency A
– Profit profiles shown at maturity

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Elementary Option Strategies
• Call Options
– Current spot rate, St
– Strike price X
– Call option premium c
– Spot rate at maturity ST
– Call Option Buyer’s Profit = -c for ST ≤ X
= ST - X - c for ST > X
– Call Option Writer’s Profit = +c for ST ≤ X
= -(ST - X - c)
for ST > X
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Elementary Option Strategies

X
0
c S(T)
(-) X+c

Option Buyer
Option Seller

Profit Profile of a Call Option


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Elementary Option Strategies
• Put Options : Premium p
– Put Option Buyer's Profit
– = -p for ST ≥ X
= X - ST – p for ST < X
– Put Option Writer’s Profit
– = +p for ST ≥ X
= -(X - ST - p) for ST < X

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Elementary Option Strategies
Option Buyer
Option Writer

+
0
X-p X

Profit Profile of a Put Option


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Elementary Option Strategies
• Spread Strategies
– Bullish Call Spread: Consists of selling the call with the
higher strike price and buying the call with the lower
strike price
– Bearish Call spread: If the investor expects the foreign
currency to depreciate, he can adopt the reverse
strategy viz. buy the higher strike call and sell the
lower strike call
– Bullish Put Spread: Consists of selling puts with higher
strike and buying puts with lower strike
– Bearish Put Spread: Opposite of Bullish Put Spread
– These strategies, involving options with same maturity
but different strike prices are called vertical or price
spreads
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Bull Spread Using Calls
Buy Call Strike X1, Premium c1;
Sell Call Strike X2, Premium c2 ;

Profit
c2

ST
X1 X2
c1

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Bull Spread Using Puts
Buy Put Strike X1, Premium p1; Sell Put Strike X2,
Premium p2

Profit
p2

X1 X2 ST

p1

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Bear Spread Using Calls

Profi
t

X1 X2 ST

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Bear Spread Using Puts

Profit

X1 X2 ST

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Elementary Option Strategies
• Butterfly Spreads – Short Butterfly
The CHF/USD spot is 0.62 Calls on CHF with
strikes 0.58, 0.62 and 0.66 USD per CHF are
trading at premiums of $0.05, $0.02 and $0.01.
– A butterfly spread is sold by writing two calls
with the middle strike price of 0.62, and buying
one call each with strike prices on either side,
here, 0.58 and 0.66
Market view: Drop in volatility; market
expected to make very small moves.

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Butterfly Spread Using Calls
Payoff Profile of a Short Butterfly
Long Calls Strike X1 and X3; Short Two Calls Strike X2

Profit

X1 X2 X3 ST

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Elementary Option Strategies

• Butterfly Spreads : Long Butterfly


• European calls on CHF are available with strikes
0.58, 0.62, 0.66 USD per CHF
– A butterfly spread is bought by buying two
calls with the middle strike price of 0.62, and
writing one call each with strike prices on either
side, here, 0.58 and 0.66
– Market View

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Elementary Option Strategies

• Horizontal or Time Spreads


– Horizontal spreads consist of simultaneous
purchase and sale of two options identical in all
respects except the expiry date
– The difference in premiums between the two
options will be moderate at the time of
initiation but will have widened at the time of
expiry of the short term option provided the
underlying exchange rate has not moved
drastically

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Elementary Option Strategies
• Straddles and Strangles
– A long straddle consists of buying a call and
a put both with identical strikes and
maturity. Usually both are at-the-money.
– A long strangle consists of buying an out-of-
the- money call and an out-of-the-money put
– Both are bets that the underlying price is
going to make a strong move up or down I.e.
market is going to be more volatile.

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A Straddle Combination
X: Strike in Put and Call
c,p: Call, Put Premiums

Profit

X ST

X-p-c X+p+c
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A Strangle Combination
X1: Put Strike X2: Call Strike
c: Call Premium p: Put Premium

Profit

X1 X2
ST

X1-p-c X2+p+c
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Hedging with Currency Options
– Hedge a Foreign Currency Payable with a
Call.
– Hedge a Receivable with a Put Option
– Covered Call Writing. Earn a premium by
writing a call against a receivable.
– Options are a convenient hedge for
contingent liabilities (Note however that the
risk of the liability materialising or not
cannot be hedged with the option)
– Options allow hedger to bet on favorable
currency movements with limited downside
risk.
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Principles of Option Pricing
• Notation
– t : The current time
– T : Number of days from t to expiry of the option i.e.
the option expires at time t+T
– C(t) : Value measured in HC, at time t, of an
American call option on one unit of spot foreign
currency
– P(t) : Value in HC, at time t, of an American put
option on one unit of foreign currency
– c(t), p(t) : Values of European call and put options
in HC
– Exchange rates, strike prices stated as units of HC
(home currency) per unit of FC (foreign currency)

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Principles of Option Pricing
Notation
– S(t) : The spot exchange rate at time t. S(t+T) is thus
the spot rate at option maturity. The spot rate is in
terms of units of HC per unit of FC
– X : The exercise or strike price, units of HC per unit
of FC
– iH : Domestic risk-free, continuously compounded
annual money market interest rate. It is assumed to
be constant
– iF : Foreign risk-free, continuously compounded
annual money market interest rate, assumed to be
constant

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Principles of Option Pricing
– BH(t,T) : Home currency price, at time t, of a pure
discount bond that pays one unit of home currency
at time t+T with continuous compounding

B = e-iH (T/ 360)


H
– BF(t,T) : Foreign currency price, at time t, of a pure
discount bond that pays one unit of foreign currency
at time t+T, with continuous compounding
B = e-iF (T/360)
F

σ(t) : Standard deviation of the spot exchange rate.

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Principles of Option Pricing
• Determinants of option values
S,X,T,iH,iF,σ
• Basic principles of option valuation
– Option values can never be negative. At any time t,
c(t), C(t), p(t), P(t) ≥ 0
– ct, Ct ≤ St and pt, Pt ≤ X
– On exercise date, the option value must equal the
greater of zero and the intrinsic value of the option
c(t+T), C(t+T) = max [0, S(t+T)-X]
p(t+T), P(t+T) = max [0, X-S(t+T)]
At any time t < T
- C(t) ≥ max [c(t), S(t)-X] ; P(t) ≥ max [p(t), X-S(t)]

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Principles of Option Pricing
– Consider two American options, calls or puts, which
are identical in all respects except time to maturity.
One matures at t+T1 while the other at t+T2 with
T2 > T1. Let C1, C2 and P1, P2 denote the premiums.
Then
C2(t) ≥ C1(t) P2(t) ≥ P1(t) for all t ≤ T1
∂C/∂T ≥ 0 ∂P/∂T ≥ 0
Two options differing only in exercise price
C(X2, t) < C(X1, t); c(X2, t) < c(X1, t)
P(X2, t) > P(X1, t); p(X2, t) > p(X1, t))
where X1 and X2 are strike prices with X2 > X1
∂C/∂X , ∂c/∂X < 0 ∂P/∂X , ∂p/∂X > 0
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Principles of Option Pricing
– At any time t we must have
c(S,X,T) + XBH(t,T) ≥ S(t)BF(t,T) or,
c(S,X,T) ≥ S(t)BF(t,T) - XBH(t,T)
and therefore
C[S(t),X,t,T] ≥ c[S(t),X,t,T]
≥ S(t)BF(t,T) - XBH(t,T)
C[S(t),X,t,T]
≥ max{[S(t) - X], [S(t)BF(t,T) - XBH(t,T)]}
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Principles of Option Pricing
– For European and American put options we
have
p[S(t),X,t,T] ≥ XBH(t,T) - SBF(t,T)
P[S(t),X,t,T]
≥ max {[X-S(t)], [XBH(t,T)-SBF(t,T)]}
Since SBF/BH = Ft,T = T-day Forward Rate at t
C[S(t),X,t,T] ≥ c[S(t),X,t,T] ≥ BH(t,T)(Ft,T-X)
P[S(t),X,t,T] ≥ p[S(t),X,t,T] ≥ BH(t,T)(X – Ft,T)

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Principles of Option Pricing
– Put-Call Parity Relationship for European Options
p[S(t),X,t,T] = c[S(t),X,t,T]+XBH(t,T)-S(t)BF(t,T)

Using the interest parity relation

p[S(t),X,t,T] = c[S(t),X,t,T]+BH(t,T)(X-Ft,T)

This can be manipulated in several ways. E.g.

Long put + Short call + Long FC bond

= Long HC bond

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Option Pricing Models
• The central idea in all the models is risk neutral
valuation
• The theoretical models typically assume
frictionless markets i.e. no transaction costs, taxes,
no restrictions on short selling, continuous trading
etc.
• A portfolio can be constructed of traded assets
which replicates option payoff
• Value of the option must be equal to value of the
portfolio irrespective of investor’s risk-return
preferences

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Option Pricing Models
• European Call Option Formula (Black-Scholes)
c(t) = S(t)BF(t,T)N(d1) - XBH(t,T)N(d2)

ln(SBF/XBH) + (σ 2/2)T
d1 = --------------------------------
σ√T d
N(d) = ∫ (
1
) e(-z2 / 2) dz
-∞ 2ππ
ln(SBF/XBH) - (σ 2/2)T
d2 = --------------------------------
σ√T
σ in the above formula denotes the standard deviation
of log-changes in the spot rate 38
Option Pricing Models
c(t) = BH(t,T) [Ft,TN(d1) - XN(d2)]

ln(Ft,T/X) + (σ 2/2)T
d1 = ----------------------------
σ√T

ln(Ft,T/X) - (σ 2/2)T
d2 = ----------------------------
σ√T
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Option Pricing Models

• European Put Option Value


p(t) = XBH(t,T)N(D1) - S(t)BF(t,T)N(D2)

= BH(t,T)[XN(D1) - Ft,TN(D2)] where, D1 = -d2


and D2 = -d1

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Option Deltas and Related Concepts:
The Greeks
• The Delta of an option
∆ = ∂c/∂S for a European call option
= ∂p/∂S for a European put option
• Having taken a position in a European option,
long or short, what position in the underlying
currency will produce a portfolio whose value is
invariant with respect to small changes in the spot
rate? A delta-neutral position is unaffected by
small changes in the underlying spot rate

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Option Deltas and Related Concepts:
The Greeks
• The Elasticity of an option is defined as the
ratio of the proportionate change in its value
to the proportionate change in the
underlying spot rate. For a European call,
elasticity would be [(∂c/c)/(∂S/S)]
• The Gamma of an option
Γ = ∂2c/∂S2 for a European call
Γ = BFN′(d1)/Sσ√T

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Option Deltas and Related Concepts:
The Greeks
• A hedge which is delta neutral as well as
gamma neutral will provide protection
against larger movements in the spot rate
between readjustments
• The Theta of an Option
Θ = ∂c/∂t for a European call
Θ = ∂p/∂t for a European put

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Option Deltas and Related Concepts:
The Greeks
• The Lambda or Vega of an Option
– Rate of change of its value with respect to the
volatility of the underlying asset price
• Concept of implied volatility
– Compute the value of σ which, when input into
the model, will yield a model option value
equal to the observed market price
• Volatility smile depicted in figure below

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Option Deltas and Related Concepts:
The Greeks

Volatility Smile
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Over-The-Counter (OTC) Market
Practices
• Like in the forex market, dealers trade
directly with each other and through
brokers
• Unless a quote for a specific option - call or
put - is requested, the market practice is to
quote a two way-price in terms of implied
volatility for an At-the-Money- Forward
(ATMF) straddle for a given period
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Futures Options

• The underlying asset in this case is a futures


contract
• A call option on a futures contract, if exercised,
entitles the holder to receive a long position in the
underlying futures contract plus a cash amount
equal to the price of the contract at that time minus
the exercise price
• A put option on being exercised gives the holder a
short position in the futures contract plus cash
equal to the exercise price minus the futures price

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Innovations with Embedded Options

• Range Forwards (Cylinder Option, Tunnel


Option)
• Participating Forwards
• Conditional Forward (Forward Reversing Option)
• Barrier Options
– Up-and-Out or Knock-out Put Option
– Up-and-In Put Option
– Down-and-Out Call Option
– Down-and-In Call Option

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Range Forwards

Price Paid

F2

F1

F1 F2 ST
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Participating Forward
Consider first the sale of a participating forward. The seller is
assured a minimum price F1 which is less than the current
outright forward rate for the same maturity. If at maturity, the
spot rate, ST, is greater than F1, the seller gets a price of [F1 + µ
(ST - F1)], where µ is a positive fraction, 0 < µ < 1. If ST < F1, the
seller gets F1.

Conditional Forward (Forward Reversing Option)


Suppose a customer is not willing to pay more than CHF 1.7500
for a dollar. He buys a conditional forward in which the seller
quotes a premium which is to be paid if and only if the price of a
dollar plus the premium is less than 1.7500.
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Barrier Options
 Up-and-Out or Knock-out Put Option
Consider a European put option on GBP against USD at a
strike price of USD 1.80 per GBP. If we build into it an additional
condition that the option ceases to exist or is "knocked out" if the
spot GBP/USD goes above 2.00 at any time during the life of the
option irrespective of what the spot rate is on the expiry date, it
becomes a Up-and-Out put or a Knock-out put. An American firm
with a GBP receivable might buy such an option to protect the
dollar value of its asset with some side arrangement with the bank
that the moment the spot goes above 2.00, a forward sale contract
will come into effect. The advantage of this option is its lower up-
front premium compared to a standard European put.

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Barrier Options
Up- and-In Put Option
In the above example, a put with a strike of USD 1.80
and a condition that the put becomes effective only if the
spot rate goes above 2.00 makes it a up- and-in put. If the
outlook for GBP is bullish in the short to medium run but
bearish in the long run a hedger or trader might use such an
option; alternatively he could buy short-maturity calls and
longer-maturity puts. The up-and-in put is a cheaper
alternative.

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Barrier Options
•  Down-and-Out Call Option
A German firm with USD payable might buy a call on USD with
a strike price of DEM 1.60 per USD with a knock-out at 1.55. It
might have an arrangement to buy USD forward the moment the
dollar moves below 1.55. This call would be cheaper than a
standard call with the same strike and maturity.
 Down-and-In Call Option
T This opposite of a down-and-out call. The down-and-in call
comes into existence only if the spot rate moves below the barrier
level. This option will be used when the view is bearish in the
short run but bullish in the long run.

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Innovations with Embedded Options
• Contingent Options and Compound Options
• Conditional Forward Contracts
• Exotic options
– Preference Options – Decide call or put later
– Asian Options
– Look-back Options: Payoff based on most favourable
rate during option life.
– Average Rate Option: Payoff based on average value of
the underlying exchange rate during option life
– Bermudan Options : exercise at discrete points of time
during option life. Sort of compromise between
American and European options.
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Empirical Studies of Option Pricing
Models
• There is substantial evidence of pricing
biases in case of the Black-Scholes as well
as alternative models
• Recent research has focussed on relaxing
some of the restrictive assumptions of the
Black-Scholes model

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Currency Options in India

• Currency options between the Indian rupee


and foreign currencies are as yet not
available in the Indian market
• Since January 1994, the RBI has however
permitted Indian banks to write "cross-
currency" options including barrier options
and other innovations.

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Summary

• An option buyer can retain the freedom to


benefit from favorable movements in the
spot rate while at the same time limiting his
loss in case of adverse movements
• They can be combined in several ways to
create financial engineering products with
unique payoff profiles

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