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Hedging with Foreign Hedging with Foreign Currency OptionsCurrency Options

International Finance – GSM 658Eli Waite

Currency OptionsCurrency Options

“A foreign currency option contract is a financial instrument that gives the holder the right but not the obligation to sell or buy currencies at a set price either on a specific date or before some expiration date.”

(The Theory and Practice of International Financial Management, Click and Coval, 2002)

What are they good for?What are they good for?

Hedging◦Potential transactions◦Transactions that depend on something else◦Uncertain demand

“Quantity Risk”

Limit downside risk, but reap most of the upside.

Details, Details, DetailsDetails, Details, Details

Call Options◦The right to buy a currency at the strike price◦Used to hedge foreign currency outflows

Put Options◦The right to sell a currency at the strike price◦Used to hedge foreign currency inflows

Details, Details, Details cont.Details, Details, Details cont.

Contract Size = 10,000 foreign currency units (1,000,000 Yen) (Source: http://www.phlx.com/products/wco_faq.html#3)

Expiration, the third Friday of the expiration month. (Source: http://www.phlx.com/products/product_specs.html)

American Options – Can be exercised ANYTIME before maturity.

European Options – Can ONLY be exercised at maturity.

How it works – Put Option

Source: (http://upload.wikimedia.org/wikipedia/en/d/d1/PutOption.png)

How it works – Call Option

Source: (http://upload.wikimedia.org/wikipedia/en/7/7f/CallOption.png)

Questions to askQuestions to ask

Strike Price?

Maturity?

American or European?

QuotesQuotes

Philadelphia Exchange◦http://www.phlx.com/

Example OneExample One

Pace Co, a cheese and wine store in Salem, OR has placed a €20,000 bid for a very rare wine from France on March 18. The results of the auction will not be known until May. The management team at Pace Co is worried that the Euro will continue its recent appreciation and would like to lock in an exchange rate so that the cost of the auction does not get out of hand without having to commit to a contract. What should they do?

Example TwoExample Two

Pace Industrials based in Salem, OR has placed a bid with the Australian government to be one of the sub-contractors to build a bridge to Tasmania for AU$2,000,000. The winning bid will be selected in June (they will be paid at that time). The management team is concerned that the Australian dollar may depreciate and wants to lock in an exchange rate incase they receive the contract. What should they do?

Questions?Questions?