GROUP IX

BSFB 206 PRESENTATION

FOREIGN EXCHANGE OPTIONS
WHAT ARE FOREX OPTIONS?
 Foreign exchange options are the derivative financial instruments that give
the right but not the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange rate on a specified
date.
 It is basically the possibility of exchanging a specific currency at a defined
rate before a fixed date.
 Forex options are used to manage or insure against foreign exchange risk or
hedge against movements in the foreign exchange rate. The option buyer pays
an option premium for protection from adverse exchange rate changes, while
the option seller accepts the risk in exchange for receiving option premium.
 The options that we are going to talk about are ;
 Call option
 Put option
HOW IT WORKS ?
 They are exercised in the options market.
 A put option gives the option buyer the right to sell the underlying currency at the strike
rate. If the option buyer exercises the put, the option seller has the obligation to accept the
currency at strike rate.
 A call option gives its buyer the right to purchase the underlying currency at the strike rate.
If the option buyer exercises the call, the option seller has the obligation to deliver the
currency at strike rate.
 Works like insurance hence the need for paying a premium (price the option buyer pays for
the right to buy or sell at a fixed future rate). If strike price is favourable than spot
exchange rate on which the option matures then it is called “expired-in-the-money” and
holder should exercise it. Vice versa it is termed “expired-out-of-the-money” and holder
may withdraw.
 The underlying currency is the currency in which an asset is valued and it is hedged against
fluctuations using protecting rates. The protecting rates will be always lower which is the
minimum threshold of the rate the holder is willing to accept.
 Foreign exchange collar: it combines purchasing and selling of options
EXAMPLE
 A Zimbabwean company imports materials from USA and needs to pay $10 000 US in six
months. Forward rate for six months Zim/ US dollar is 0.5 protecting a rate of 0.45. A
premium is paid for the protection offered for a certain price.
 Here the standard FX quotation, i.e base/denominator and the underlying currency is
the currency in which an asset ie the imported material is valued in the US dollar in
this case. We hedge against fluctuations in the US dollar.
 1) Zimbabwe/USA $ weakens and becomes 0.25 then you are entitled to buy your full
$10 000 at the protected rate of 0.45.
 2) Zimbabwean / USA $ strengthens and becomes 1, then you let your company option
expire and simply buy at market rate of 1, thus benefiting from the improvement in
the FX rate. It is evident that profits can be pocketed from this scenario.
 IVC=S-E and inverse for IVP where IVP/C is Inherent Value of Put/Call
S is Stock price and E is the strike
 TVC= C-IVC where C is the Call and TVC is total value of Call
ADVANTAGES AND DISADVANTAGES
ADVANTAGES
 Theoretically call options have unlimited profit potential and limited risk.
 Flexibility – with options you can trade any type of potential move in the underlying security. Think the shares might
double within a week perhaps you believe the shares will hardly move over the next month. You can even use them to
protect your downside. Options are good tools for trading upwards and downwards even sideways price movements.
 Gain leverage-options can offer incredible leverage and returns of 100% or even higher are possible. This leverage can
be used intelligently. For example, options can be used to take a position in a stock using a small down payment.
 Sell options against shares that you already own- this is called a covered call strategy and it is a way to earn extra
income from shares you already hold
 Speculation- Generally used to speculate the future exchange rates by market markers.
DISADVANTAGES
 Leverage- leverage is good when making money but very horrible when losing it as it means all losses are multiplied.
Most traders who suffer losses in options do so because they use too much leverage.
 Complex – it is time consuming especially to be a real pro.
 Volume – some options don’t trade that much which in turn means that there is little liquidity. If no liquidity the bid-
offer spreads can be gross wide sometimes as much as 10%. With spreads like that it is almost impossible to make
money. If the volume is low don’t get involved in these options.
 Since it is used in speculation, there is high risk of information assymetry since some parties may make an
advantage by purchasing options and simultaneously exchanging on the spot market to pocket the difernce.
FACTORS FOR AND FACTORS AGAINST
FOREX OPTIONS
 Time frame
 Parties involved (intentions of the parties involved may be questionable)
 Methods of options applicable in market. There are average rate options
whose payoff depends on average exchange rate and barrier option whose
payoff is contingent on the exchange rate reaching a certain level.
 Economic instability.
 Central bank policies and government regulations
 International governing bodies(EU)
 Market forces that is demand and supply
THE END
THANK YOU

 Presented by:
 Roween Mashiri
 Rutendo Mupani
 Tanyaradzwa Leigh Masunga
 Simbarashe Jaji
 Tatenda Shokora
 Fidelis Mutsvauki
 Hollywood T Chikomo
 Tinashe Uzhenyu
 Blessing S Murwira
 Tafadzwa Manyati
 Aubrey T Mubonani