International Trade and Finance: A North American Perspective

By Khosrow Fatemi | Go to book overview

10
CURRENCY RISK MANAGEMENT USING OPTIONS

JOSEPH F. SINGER AND RAY D. SIEHNDEL


INTRODUCTION

Options are the most versatile and least understood instruments on the currency markets. They are often viewed as purely speculative instruments, but they have other uses as well. Options, for example, can provide an excellent means of hedging commercial or financial exposures.

Options differ fundamentally from cash market (spot and forward) transactions. With cash market transactions, you are entitled to profit when the price moves your way and you are obligated to accept losses if it moves against you. The chance of a loss is the cost you pay for the opportunity of a gain. A buyer of an option has the right but not the obligation to exchange currencies at a fixed rate at some point in the future. In the case of options, when the price moves your way you profit, but when the price moves against you, you lose nothing except your fixed initial premium.

Figures 10.1 and 10.2 illustrate the difference between a purchase of pounds sterling at $1.15 and an option to buy sterling at $1.15. These charts show the profit or loss of a position (on the vertical axis) of a given sterling price (on the horizontal axis). Figure 10.1 shows the profit profile of a spot purchase of sterling. If sterling trades above $1.15, the investor earns a penny for every penny the price rises. If it trades below $1.15, he loses a penny for every penny the price falls. If sterling remains the same, there is no gain or loss and the investor breaks even. Figure 10.2 shows the profit profile of an option to buy sterling at $1.15. The investor pays a premium of 2 cents. If sterling trades above $1.15, he receives one penny for every penny sterling rises. When sterling reaches $1.17, the 2-cent value of the option fully offsets the initial cost and the investor breaks even. Above $1.17, the investor earns a penny-for-penny profit as sterling rises.

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