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Understanding Call Options in Forex: Setting an Upper Limit for Short Positions, Slides of Management Fundamentals

Mizoram UniversityManagement Fundamentals

An explanation of call options in the context of foreign exchange, highlighting their benefits for hedging firms in establishing an upper limit for open short positions and the ability to walk away from the contract if the exchange rate moves in their favor. The document also includes examples and questions to test understanding.

Typology: Slides

2012/2013

Uploaded on 07/26/2013

devnarayan
devnarayan 🇮🇳

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Review of Put Option Example
We can see from the previous example, that
with the use of a put option, the hedging firm
was able to establish (“lock in”) a lower limit
for its open long FX position.
The hedging firm can also walk away from
the put contract if the exchange rate moves in
its favor (i.e., take advantage of the upside
potential if the foreign currency strengthens).
Recall that this was not possible with a
forward contract.
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Download Understanding Call Options in Forex: Setting an Upper Limit for Short Positions and more Slides Management Fundamentals in PDF only on Docsity!

Review of Put Option Example 

We can see from the previous example, thatwith the use of a put option, the hedging firmwas able to establish (“lock in”) a lower limitfor its open long FX position.

The hedging firm can also walk away fromthe put contract if the exchange rate moves inits favor (i.e., take advantage of the upsidepotential if the foreign currency strengthens).

Recall that this was not possible with aforward contract.

FX Call Option  Call options allow a hedging firm to buy a (1) specifiedamount of foreign currency at (2) a specified future dateand at a (3) specified a price (i.e., at an exchange rate)all three of which are set today.  A call option is a potential “long” position so it can beused to offset a foreign currency short position.  Call options provides the holder with an upper limitprice (“ceiling”) for the foreign currency the firm needsin the future.  If the future spot rate proves to be advantageous (i.e.,the foreign currency weakens), the option holder willnot exercise the call option, but instead buy the foreigncurrency in the spot market.  Flexibility to take advantage of a favorable change in theexchange rate (i.e., a weak foreign currency).

Call Option Example -- Continued

Assume in 30 days the GBP-USD spot rate is:1.8400/1.8600 

Question: What has the pound done from the spotrate 30 days ago (1.7200/1.7400)?  Question: What is the amount of account payable atthis current spot rate and how does this compare tothe rate 30 days ago?  Question: What should the U.S. firm do with itsoptions contract?  Question: Given the current spot rate, what will bethe optimal USD amount with this strategy?

Answer: Call Option Example

Assume in 30 days the GBP-USD spot rate is:1.8400/1.8600 

What has the pound done from the spot rate 30 daysago (1.7200/1.7400)?  Pound has strengthened, by $0.1200 per pound  Account payable will now require $186,000 at thisspot ask rate (or $6,000 more than on originationdate).  What should the U.S. firm do?  U.S. firm should exercise its call option and buypounds at the strike price of $1.8000.  Firm will pay $180,000 plus the $3,000 up front fee, or$183,000, for the pounds

Answer: Call Option Example

Assume in 30 days the GBP-USD spot rate is:1.6500/1.6600 

What has the pound done from the spot rate 30 daysago (1.7200/1.7400)?  Pound (ask) has weakened, by $.0800 per pound  Account payable will now require $166,000 at thisspot rate (or $8,000 less than on origination date).  What should the U.S. firm do?  U.S. firm should not exercise its call option and insteadbuy pounds at the current spot rate of $1.6600.  Firm will pay $166,000 plus the $3,000 up front fee, or$169,000, for the pounds.

Review of Call Option Example 

We can see from the previous example, thatwith the use of a call option, the hedging firmwas able to establish (“lock in”) a upper limitfor its open short FX position.

The firm can also walk away from the callcontract if the exchange rate moves in itsfavor (i.e., take advantage of the upsidepotential if the foreign currency weakens).

Recall that this was not possible with aforward contract.

Factors Affecting Options’Premiums^ Parameter

Call Premium Put Premium Strike Price As strike price increases(relative to the spot) thecall premium decreases As strike price decreases (relativeto the spot) the put premiumdecreases Time to maturity As time to maturity increases, the likelihood of the option beingexercised increases, thus the premium increases. Volatility As volatility increases there is high degree of potentialmovement about the spot rate of the currency. Thus thegreater the volatility, thus the premium increases. Volatility iswithout a doubt the most important factor of the options’ pricingfactors.