Transcript Hedging with Foreign Currency Options

International Finance – GSM 658
Eli Waite
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“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)
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Hedging
◦ Potential transactions
◦ Transactions that depend on something else
◦ Uncertain demand
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“Quantity Risk”
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Limit downside risk, but reap most of the upside.
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Call Options
◦ The right to buy a currency at the strike price
◦ Used to hedge foreign currency outflows
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Put Options
◦ The right to sell a currency at the strike price
◦ Used to hedge foreign currency inflows
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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)
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Strike Price?
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Maturity?
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American or European?
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Philadelphia Exchange
◦ http://www.phlx.com/
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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?
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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?