ESSEC

Business School

International Finance

CLASS HANDOUTS

SESSION 5

Peng Xu

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 Hedging Currency Risk with Options

Outline

– Options

– Hedge Risk Using Currency Options

– Determinants of Option Value

– Calculating Option Price

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 I. Options

– An option gives the holder the right, but not the obligation, to

buy or sell a given quantity of an asset in the future at prices

agreed upon today.

– Calls vs. Puts:

• Call options give the holder the right to buy a given quantity

of some asset at some time in the future at prices agreed

upon today.

• Put options give the holder the right to sell a given quantity of

some asset at some time in the future at prices agreed upon

today.

– European versus American options:

• European options can only be exercised on the expiration

date while American options can be exercised at any time up

to and including the expiration date.

• American options are usually worth more than European

options, other things equal.

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 I. Options

- Example:

Price of different options on Danone on August 27, 2012. The

price of the stock on that day is 50.82.

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 I. Options

– Option Positions:

• Long call: buy call options

• Long put: buy put options

• Short call: sell (or write) call options

• Short put: sell (or write) put options

- Notation:

𝐶! : Price (premium) of a call option at time 0

𝑃! : Price (premium) of a put option at time 0

𝐶" : Price or payoff of a call option at time 𝑇

𝑃" : Price or payoff of a put option at time 𝑇

𝑆" : Price of the underlying asset at maturity date 𝑇

𝐾: Exercise price, also called strike price

– Payoff and net profit of options at maturity 𝑇:

• Long call:

The payoff is: 𝐶" = 𝑀𝑎𝑥(𝑆" − 𝐾, 0)

The net profit is 𝐶" − 𝐶! = 𝑀𝑎𝑥(𝑆" − 𝐾, 0) − 𝐶!

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 I. Options

𝐶! Payoff

Profit

𝐾 𝑆!
−𝐶"

• Long put:

The payoff is: 𝑃" = 𝑀𝑎𝑥(𝐾 − 𝑆" , 0)

The net profit is 𝑃" − 𝑃! = 𝑀𝑎𝑥(𝐾 − 𝑆" , 0) − 𝑃!

𝑃!

Payoff

𝑆!
Profit

𝐾 𝑆!
−𝑃"

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 I. Options

• Short call:

The payoff is: −𝑀𝑎𝑥 (𝑆" − 𝐾, 0) = 𝑀𝑖𝑛(𝐾 − 𝑆" , 0)

The net profit is 𝑀𝑖𝑛(𝐾 − 𝑆" , 0) + 𝐶!

𝐶"

𝐾
𝑆!

Payoff Profit

• Short put:

The payoff is: −𝑀𝑎𝑥 (𝐾 − 𝑆" , 0) = 𝑀𝑖𝑛(𝑆" − 𝐾, 0)

The net profit is 𝑀𝑖𝑛(𝑆" − 𝐾, 0) + 𝑃!

𝑃"
𝐾
𝑆!
Profit

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 I. Options

– At any time 𝑡,

• An option is “in the money" if the (virtual) immediate exercise

of the option generates a positive payoff.

Call: 𝑆# > 𝐾,

Put: 𝑆# < 𝐾

• An option is “at the money" if the (virtual) immediate exercise

of the option generates a zero payoff.

i.e., 𝑆# = 𝐾

• An option is “out of the money" if the (hypothetical)

immediate exercise of the option generates a negative payoff.

Call: 𝑆# < 𝐾,

Put: 𝑆# > 𝐾

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 I. Options

– There are three broad categories of traders:

• Hedgers: use derivatives to reduce the risk that they face

from potential future movements in a market variable.

• Speculators: use derivatives to bet on the future direction of

a market variable.

• Arbitrageurs: take offsetting positions in two or more

instruments to lock in a profit

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 I. Options

– Hedging using Options

Example: suppose you own 1000 shares of IBM stock. The

share price is $28 per share. You are concerned about a

possible share price decline in the next 2 months and want

protection.

Assume a two-month put with a strike price of $27.50 costs $1.

Profit of
Holding ($)

No Hedging
Hedging

Stock Price ($)

20 25 30 35 40

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 I. Options

– Speculating using Options

Example: An investor with $2,000 to invest feels that a stock

price will increase over the next 2 months. The current stock

price is $20 and the price of a 2-month call option with a strike

of 22.50 is $1. What are the alternative strategies?

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 I. Options

– Put-Call Parity for European Options (No Dividend)

𝑐 + 𝐾𝑒 $%" = 𝑝 + 𝑆

where

𝑆 : Price of the underlying asset

𝑐: Price of a European call with strike K and Maturity T

𝑝: Price of a European put with strike K and Maturity T

𝑟: Continuously compounded risk-free interest rate with maturity

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 II. Hedge Risk Using Currency Options

– Currency options are primarily traded in the over-the-counter

(OTC) market, where large trades are possible, with strike

price, maturity, and other features tailed to the needs of

corporate treasurers.

– Currency options are used by corporations to buy insurance

when they have an FX exposure

• A company due to receive some foreign currency at a known

time in the future can hedge its risk by buying a put option on

the foreign currency.

• A company due to pay some foreign currency at a known

time in the future can hedge its risk by buying a call option on

the foreign currency.

• Example:

A US company is going to receive 1 million pounds sterling in

three months. Suppose that the three-month forward

exchange rate is 1.5200 dollars per pound. A European put

options with strike price 1.5 and three months to maturity is

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 II. Hedge Risk Using Currency Options

worth 0.03250. A European call options with strike price

1.5413 and three months to maturity is also worth 0.03250.

What are the alternative hedging strategies?

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 II. Hedge Risk Using Currency Options

– Options Market Hedge

• Unlike forward market and money market hedge, options

hedge allows the firm to limit the downside risk while

preserving the upside potential.

• However, you need to pay for buying an option.

• A British importer who will pay €100,000 (buy euros and sell

pounds) in one period can:

Buy call options on the euro with a strike in pounds.

Buy put options on the pound with a strike in euros.

• A British exporter who will receive €100,000 (sell euros and

buy pounds) in one period can:

Buy call options on the pound with a strike in euros.

Buy put options on the euro with a strike in pounds.

• A motivated financial engineer can create almost any risk-

return profile that a company might wish to consider.

Various trading strategies

Exotic options

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 II. Hedge Risk Using Currency Options

• Options can be useful for hedging contingent exposure

Example:

Suppose General Electric (GE) is bidding on a

hydroelectric project in Canada. If the bid is accepted,

which will be known in 3 months, GE is going to receive

C$100m. GE wants to hedge the potential currency risk of

C$ depreciation.

In this case, long put options is a better hedging tool than

short C$ forward.

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 III. Determinants of Options Value

– Determinants of Options Value

Variable European European American American

Call Put Call Put
S0 + − + −

K − + − +

T ? ? + +

𝜎 + + + +

r + − + −

rf − + − +

1. Actual price of the foreign currency:

§ Call option: For a given strike, ↑ spot price of the foreign

currency, ⇒ ↑ probability that it will have high payoff on

exercise.

§ Put option: For a given strike, ↑ spot price of the foreign

currency, ⇒ ↓ probability that it will have high payoff on

exercise.

2. Strike:

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 III. Determinants of Options Value

§ Call option: For a given price of the foreign currency,

↑ strike ⇒ ↓ prob that it will have high payoff on exercise.

§ Put option: For a given price of the foreign currency,

↑ strike ⇒ ↑ prob that it will have high payoff on exercise.

3. Maturity:

§ American options: ↑ maturity ⇒ ↑ opportunities

§ European options:

Ø ↑ maturity can usually increase the probability the price

of the foreign currency reaches a certain level, when r

and rf are not too different in size. Hence, higher T,

higher European option prices.

Ø However, if r is much larger than rf, a European FX call

price will increase, when T increases, but a European

put will decrease.

Ø The opposite is true when rf is much larger than r.

4. Volatility in the price of the foreign currency:

↑ volatility ⇒ ↑ probability that the price of the foreign

currency be greater (call) or lower (put) than the strike.

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 III. Determinants of Options Value

5. Domestic Interest rate:

§ Call option: Holding all the other variables the same,

↑ interest rate ⇒ ↓ PV(strike) that the investor will pay.

§ Put option: Holding all the other variables the same,

↑ interest rate ⇒ ↓ PV(strike) that the investor will get.

6. Foreign Interest rate:

The price of foreign currency is expected to decrease with

higher rf. This is bad for call, but good for put.

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 IV. Calculating the Price of Options

– Pricing of Currency Options

• Formulas for European Currency Options:

𝑐 = 𝑆! 𝑒 $%!" 𝑁(𝑑' ) − 𝐾𝑒 $%" 𝑁(𝑑( )

𝑝 = 𝐾𝑒 $%" 𝑁(−𝑑( ) − 𝑆! 𝑒 $%!" 𝑁(−𝑑' )

where

𝑆! 𝜎(
ln A 𝐾 B + C𝑟 − 𝑟) + 2 E 𝑇
𝑑' = , 𝑑( = 𝑑' − 𝜎√𝑇
𝜎√𝑇

𝑟 and 𝑟) are continuously compounded, 𝜎 is the annualized

volatility of the foreign currency, T is number of years to

maturity.

• Alternatively

𝐹!," = 𝑆! 𝑒 +%$%! ,"

𝑐 = 𝐹!," 𝑒 $%" 𝑁(𝑑' ) − 𝐾𝑒 $%" 𝑁(𝑑( )

𝑝 = 𝐾𝑒 $%" 𝑁(−𝑑( ) − 𝐹!," 𝑒 $%" 𝑁(−𝑑' )

where

𝐹!," 𝜎(
ln C 𝐾 E + 2 𝑇
𝑑' = 𝑎𝑛𝑑 𝑑( = 𝑑' − 𝜎√𝑇
𝜎 √𝑇

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 IV. Calculating the Price of Options

– Example:

Calculate the value of an eight-month European put option on a

currency with a strike price of 0.50. The current exchange rate

is 0.52, the volatility of the exchange rate is 12%, the domestic

risk-free interest rate is 4% per annum, and the foreign risk-free

interest rate is 8% per annum.

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