FX, Derivatives and DCM workshop I. Introduction to Options

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1 Introduction to Options

2 What is a Currency Option Contract? A financial agreement giving the buyer the right (but not the obligation) to buy/sell a specified amount of currency at a specified rate on a specified date 100% protection 100% participation

3 How does it compare to the Forward? A financial contract whereby the owner has the obligation to buy/sell a specified amount of currency at a specified rate on a specified date 100% protection 0% participation

4 Definitions Call Option The right to buy a specified amount of currency at a specified rate Put Option The right to sell a specified amount of currency at a specified rate Premium Strike The price of an option The rate at which the right can be exercised Expiry Date The date at which the right can be exercised

5 Types of Options OTC Options European style Option Option only exercisable on the expiry date American style Option Option exercisable at any time until expiry Listed Options Chicago IMM, Philadelphia

6 Terminology Unlike futures and forward positions, you have to pay for an option. The amount you pay is known as the Option Premium The Intrinsic value of an option is how much you could get from exercising the option immediately. An American option premium, of course, will always at least as great as the option s intrinsic value. The different between the option premium and the intrinsic value is known as the Time Value

7 Term Cont d An Option is in-the-money if its intrinsic value is positive, and out-of-the-money otherwise. An atthe-money option is one with a strike price close to the underlying asset price.

8 Hedging: Option can be used as investments, or to hedge the downside risk of an existing foreign currency exposure. In both cases, it is common to work with payoff diagram, which show what is the terminal payoff from holding a (European) option conditional on where the spot exchange rate ends up. That terminal payoff depends upon whether the spot exchange rate ends up above or below the strike price, and whether the option is a call or put.

9 Hedging Cont d Buying options can offset the downside foreign currency risk of a position, while retaining the upside potential at a cost. Options are insurance against bad realizations of the exchange rate. Buying call options ensures the right to acquire foreign currency at a prespecified price (e.g., to pay off a future liability), while allowing you to forego that right if you can get a cheaper price in the spot market.

10 Hedging Cont d Buying put options ensures the right to sell foreign currency (future accounts receivable) at a prespecified price, while allowing you to sell at a higher price in the spot market if chance premits.

11 Option VS Futures (FWD) profit Long futures Long call Futures price The buyer of an option has the right but not the obligation to perform Unlike the long futures strategy, the long call strategy has an asymmetric payoff The upside potential, however is less than that for a futures strategy by an amount equal to the option price loss

12 Right VS Obligation profit long put Long call Only rights Short futures Long futures rights Option buyers loss price profit obligations Option sellers loss Short put short call Only obligations

13 The Four Basic Option Payoffs Thus, the four basic option positions - buy a call, sell a call, buy a put, sell a put - can be summarized using a diagram: BUY PUT BUY CALL SELL PUT SELL CALL

14 What would an importer do? Underlying exposure is to pay suppliers USD (Short USD) To hedge this exposure, an importer needs to buy USD sell THB Buy USD Call THB Put at expiry, an importer has the right to buy USD and sell THB Sell USD Put THB Call at expiry, an importer has the obligation to buy USD and sell THB

15 Buy European USD Call European style USD Call/THB Put Spot THB/USD Spot at Expiry Strike > Strike: Option is exercised (value date = spot date) Expiry Amount 3 months USD1,000,000 = Strike: Option expires without value Premium 0.30 < Strike: Option expires without value

16 P/L at Expiry (Buy European USD Call) P&L 100% participation below % protection above Spot at expiry Upfront Premium (Strike) 43.80

17 Sell European USD Put European style USD Put/THB Call Spot THB/USD Spot at Expiry Strike > Strike: Option expires without value Expiry Amount 3 months USD1,000,000 = Strike: Option expires without value Premium 0.30 < Strike: Bank exercises option (Granter inherits OTM position)

18 P/L at Expiry (Sell European USD Put) P&L Upfront Premium (Strike) Spot at expiry 42.20

19 What would an exporter do? Underlying exposure is to receive USD (Long USD) To hedge this exposure, an exporter needs to sell USD buy THB Buy USD Put THB Call at expiry, an exporter has the right to sell USD and buy THB Sell USD Call THB Put at expiry, an exporter has the obligation to sell USD and buy THB

20 Buy European USD Put European style USD Put/THB Call Spot THB/USD Spot at Expiry Strike Expiry 3 months Amount USD 1,000,000 Premium 0.30 > Strike: Option expires without value = Strike: Option expires without value < Strike: Option is exercised (value date = spot date)

21 P/L at Expiry (Buy European USD Put) P&L 100% protection below % participation above Spot at expiry Upfront Premium (Strike)

22 Sell European USD Call European style USD call/thb Put Spot THB/USD Spot at Expiry Strike > Strike: Bank exercises option (Granter inherits OTM position) Expiry Amount 3 months USD1,000,000 = Strike: Option expires without value Premium 0.30 < Strike: Option expires without value

23 P/L at Expiry (Sell European USD Call) P&L Upfront Premium (Strike) Spot at expiry 43.80

24 Call - Put Parity From the diagram, we can see that: Long Forward = Long Call + Short Put Note: it holds only for European options of the same strike

25 RISK/REWARD CHARACTERISTICS

26 RISK/REWARD CHARACTERISTICS The figures illustrate two of the most important characteristics of options: buyer of options have limited risk and potential unlimited reward. sellers of options have limited reward and potential unlimited risk. So what will you do? Buy or sell..

27 RISK/REWARD CHARACTERISTICS You may realize that almost any trade in stock or futures market carries unlimited risk. The limited or unlimited risk/reward characteristics of a trade are not the only considerations. At least as important is the probability of that unlimited profit or loss.

28 RISK/REWARD CHARACTERISTICS Buying an option does not lead to a guaranteed gain, once the premium is taken into account. If fairly priced, no single option can dominate any other option for all possible future outcomes.

29 Exercise Spot = Buy $1 1-month 110 $ call Sell $1 1-month 115 $ call Buy $1 1-month 120 $ call What is the payoff diagram (hockey stick)? Can the structure be zero cost?

30 P/L Diagram

31 P/L Diagram

32 DIRECTION UNDECIDED ANDISING VOLATILITY P/L Long straddle X spot long straddle: Buy a call and buy a put with same strike, same maturity, and same amount. P/L Long strangle X 1 X 2 Long strangle: Buy a put (lower strike) and buy a call (higher strike), with same maturity and same amount. spot

33 Butterfly Buy a straddle and sell a strangle with same notional and maturity P/L X 2 X 1 X 3

34 Risk Reversal Buy a low delta $ call (put) and sell a low delta $ put (call) e.g. Buy $1 mio 1-month 40 $ call P/L Sell $1 mio 1-month 38 $ put

35 Some principals The larger the potential positive payoff, the more expensive the option strategy the way to reduce up-front cost is reduce the potential positive payoff increase the potential negative payoff change the notional amount

36 BULLISH AND UNDECIDED VOLATILITY Bull spread Buy a call (X 1 ) and sell a call (X 2 ), with X 1 < X 2 Buy a put (X 1 ) and sell a put ((X 2 ), with X 1 < X 2 P/L Bull spread X 1 X 2

37 BEARISH AND UNDECIDED VOLATILITY Bear spread Sell a call (X 1 ) and buy a call (X 2 ), with X 1 < X 2 Sell a put (X 1 ) and buy a put ((X 2 ), with X 1 < X 2 P/L Bear spread X 1 X 2

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