FINANCIAL RISK MANAGEMENT MSC-FI 2022/2023

OPTIONS MARKETS

What is an option? This is a contract that gives the holder the right but not an obligation to sell or
to buy a fixed quantity of underlying assets at a stated price/fixed price (Exercise or strike price) at
any time on or before a given date (expiration date)

The following are the examples of options:

• Stock options
• Foreign currency options
• Index options
• Futures options
• Convertible bonds or preferred stocks

Currency options quotations and prices

Every option has three price elements:

Exercise Price: This is the exchange rate at which the foreign currency can be purchased or sold.
It is the price at which the holder of the currency option is allowed to buy or sell the Currency.
This is also known as Strike Price.

Premium: This is the cost or value of the option itself. It is the amount initially paid by the owner
of the call option for the right to purchase or sell the currency. This means the holder of the
contract (buyer of the option) pays the writer (Seller of the option) and this will be kept by the
writer no matter what happens, irrespective of whether the holder decides to exercise or not. This
is a price that the buyer needs to pay in order to acquire the right. It is determined by the supply
and demand of the option.

Underlying or Actual spot rate: This is the actual market price of the security currently in the
market. Is the price at which the option can be sold or bought at the market.

Types of currency options

There are mainly two types of options. These are:

a) Call option: This gives the holder the right to buy a currency. At same time; it gives the
writer an obligation to sell the currency. The call writer agrees and has an obligation to sell
the underlying assets at a fixed price to the call buyer.

b) Put option: This gives the holder the right to sell the currency. At the same time it gives the
writer an obligation to buy the currency. The put writer agrees and has an obligation to sell
the underlying asset at a fixed price from the put buyer.

These two types of option can be in the following forms of options:-

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Double option. Also known as two-way option or straddle. This gives the right to buy or sell.
Naked Option. This is an option that is held in its own and not as a hedge against loss.
American Style Option. This is an option which can be exercised at any time up to and including
the expiration date.
European Style Option. This is an option, which can only be exercised at the expiration date itself.
Over the counter option. (OTC) Also known as negotiated option, it is a tailor made currency
option from a bank suited to the company’s specific needs.
Traded options. This is a standard option in certain currencies only from an option exchange.

Long and short position

The holder (buyer) of the option is described as holding Long position when a company exports
and invoiced in foreign currencies is described as holding long position while the writer (seller) of
option holds the short position on the same options. When a company imports is described as
holding short position.

The following are the various possibilities:

Long call position: When you hold an option to buy the underlying asset, you are in the long
position in the option contract. This gives the buyer the right to buy the call option.
Short call position: When you hold an option to sell [i.e. write], you take a short position in the
option contract. This implies a commitment to sell a currency to the holder of the option if he
decides to exercise.
Long put position: This gives the buyer the right to sell the currency
Short put position: This implies a commitment to sell a currency from the holder of the option if
the holder decides to exercise.

Hints:
Buy Call = Long call Buy Put = Long put
Sell Call = Short call Sell Put = Short put

Exercise Decision of the options at time‘t’

Let X be the exercise price
Let S be the market price/actual spot price in the market
Let Y is the currency to be bought or sell
Assume there is no premium cost:

Money ness when The call is the put is

S> X In – the – money Out – of – the – money

S=X At – the – money At- the – money
S< X Out – of – money in – the – money

Decision at Time ‘t’

For call option For Put Option

Exercise if S> X if S<X

Not exercise if S≤ X if S≥X

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Options situation

The options can be in the following situations:

IN–THE-MONEY: An option is said to be in the money when if it were exercised today a profit
would be made. Exercise price is more favorable than the market price. A call options is ITM if
Exercise price < Underlying market price. That is, if one has a right to buy at a lower price than if
he could buy at the market, and then sell to the market, there is a profit by taking the difference.
A put option is ITM if exercise price > Market price. That is, if one can sell his security at higher
price than if he could sell it at the market, then there is a profit by taking the difference.

OUT–OF–THE-MONEY: An option is said to be out of the money when if it were exercised

today a loss would be made. Exercise price is less favorable than the market price.
A call option is OTM if exercise price > Market price. So in this case it would not be exercised at
all. The holder will leave it lapse worthless and buy it in the market where the price is less.
A put option is OTM if exercise price < market price. If the exercise price of the put option is
below the security market price then, it would not be exercised. But he will opt to sell in the
market.

AT–THE–MONEY: An option is said to be at the money when the exercise price is the same as
market price. The holder will exercise the option without expecting a profit or loss.

DEEP–IN–THE MONEY: This is when option is in the money but in large amount. This cover
the option premium and yield a potentially unlimited net profit since this is a zero sum game, the
profit from selling a call is the mirror image of the profit from buying the call.

Example
A trader holds a call option and a put option on the Australian Dollar. The call gives the trader the
right to buy AUD 1 million at an exchange rate of 0.75 USD/AUD. The put gives the right to sell
AUD 1 million at the same exchange rate. What will happen if, at maturity the actual spot
exchange rate is (a) 0.80 USD/AUD (b) 0.65 USD/AUD?

Intrinsic Value
For an option, the intrinsic value is the difference between the value of the underlying asset and the
exercise price of the option. It is the option’s value if it is exercised now. It is the extent to which
the option is in the money. For a call option, the intrinsic value is given by: V i,t = St – E where Vi,t
is the intrinsic value at time ‘t’ and St is the spot rate prevailing then. If St ≤ E, then Vi,t =0
[meaning there is no –ve intrinsic value as the option will not be exercised]

For a put option, Vi,t = E- St and hence if St ≥ E, then Vi,t =0 [meaning there is no –ve intrinsic
value as the option will not be exercised]

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Time Value
This is any value over and above the intrinsic value of an option. Time value is essentially the
value of the bet associated with holding the option until the expiry date. The value is attributable to
the possibility of changes in the value of the underlying asset between now and expiry date. For a
call option, the time value is linked to the probability of the rise in value of the underlying asset
[St], while for a put option; this is linked to the probability of a fall in the value of the underlying
asset [St]. Time value is linked to the volatility of the underlying asset’s value.

Option Premium
This is the price or cost of an option contract which is comprised of both the intrinsic value and
time value. The potential loss of an investor in an option is limited to the premium paid to acquire
the option contract.
Note: Time value = premium – intrinsic value or premium = intrinsic value + time value.

If an option is extremely deep in the money or it is very close to expiry, then the premium strictly
reflects the intrinsic value. i.e. the premium will be higher to compensate its extremely deep in the
money.

Illustration
Prices of traded share options quoted in tables, such as the following for options on shares at the
London International Forward, Futures and Options Exchange [LIFFE] are given below:

LIFFE: Reuters-underlying security price 679 pence on 7th May

Calls puts
Exercise price Jul Oct Jan Jul Oct Jan
650 52 67 84 14.5 24 31.5
700 25 41 58 37.5 44.5 55
Required:
Compute the Intrinsic value and Time value of Reuters share options

The value of the option depends on the following:

1. The current price of the asset
2. The exercise price
3. The volatility (standard deviation) of the asset value
4. The time period to expiry
5. The risk free rate of interest

Feature of a currency option

1. It confers only a right and not obligation to exercise an option

2. It can be obtained over the counter or at an organized exchange
3. It can be exercised at any date (American ) or at maturity only (European)
4. If the option is not exercised, the only thing that an investor losses is the premium that he
had paid.

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Question One

Briefly explain the uses of currency options.

Times Square Public Limited Company is a Great Britain based Exporter. It has invoiced a
customer in the United States of America for US $ 1,058,000 payable on 30th June.

The current US $/₤ spot is: 1.7296-1.7330

The company wishes to hedge its foreign exchange risk exposure using traded currency options.
The ₤ June calls with an exercise price of 1.70 have a premium of 0.09. The ₤ call option contracts
are in respect of ₤ 25,000. Option premiums are quoted in $ per £.

Required:
(i) Set up the option hedge and calculate the option cost.
(ii) If on 30th June, the US $/₤ spot is 1.8460-1.8550, advise Times Square Plc on whether
it should allow the options to lapse or exercise them.

Question Two
Renaissance Investment Group is a Tanzanian company that expects to receive US $ 100,000 from
a customer in USA on October 2023. It is worried that the US $ will fall in value over the next few
months and is thinking of hedging the currency exposure with an Over the Counter [OTC]
currency option. The following option prices are available for October 2023 expiry date, for call
and put options on the US $ in exchange for the Tanzanian shillings [TZS]. Prices are quoted in
TZS per US $

Strike Price Call Options Put options

TZS 1600 TZS 2.50 TZS 1.05
TZS 1650 TZS 1.55 TZS 2.10

Required:
i. Show how an option hedge would be constructed, and what would be the option cost for
each of the two strike prices.
ii. Assume that the spot exchange rate in October 2023 when the options expire is TZS 1500
per US $, explain the action the company should take and indicate the effective exchange
rate for each of the two strike prices.

Question Three
Mabibo Company Limited, a leading cashew nut processor and exporter in Tanzania expects that it
will need Malawian Kwacha [MK] 100 million in one year. The existing spot rate of the Malawian
Kwacha is TZS 12.7. The one year forward rate of the Malawian Kwacha is TZS 12.5. Mabibo
created a probability distribution for the future spot rate in one year for unhedged strategy as
follows:
Future spot rate [TZS] Probability [%]
12.0 30
12.5 50
13.0 20

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Assume that one year put options on Malawian Kwacha are available, with an exercise price of
TZS 12.6 and a premium of TZS 0.8 per unit. One year call options on Malawian Kwacha are
available with an exercise price of TZS 12 and a premium of TZS 0.6 per unit.

Required
As a newly appointed company Treasurer, critically analyze the situation and accordingly, advice
the management on the best position to take.

Question Four
As it is now May, assume a UK- based firm has invoiced its USA customer for US$ 380,000,
payable on the 31st December. More data is provided as below:
Current spot rate US$ /₤ 1.8773 – 1.8791 The December Sterling option contracts (with contract
size ₤ 25,000) are quoted as;

December Options:
Exercise Prices: Calls puts
US$ 1.85 15.6 5.36
US$ 1.90 12.45 9.23
US$ 1.95 8.25 11.47
Premiums in cents / ₤

Supposing the UK firm decides to use the sterling options with an exercise price of US$ 1.90/₤ to
sell its dollar denominated receivables; what would be the outcome if;
(a) As at 31st December, the spot rate US$/₤ is 1.8665 – 1.8675
(b) As at 31st December, the spot rate US$ / ₤ is 1.9045 – 1.9525

Question Five
A British Company needs to hedge the receipt of US $ 10,000,000 from an American customer at
the end of June. The spot rate is $/₤ 1.4461 - 1.4492 and the 30 June forward rate is $/₤ 1.4050 -
1.4101. The following currency options are available:

Sterling ₤ 31,250 contracts (cents per ₤)

Exercise price calls puts
$/₤ June June
1.4000 5.74 7.89
1.4250 3.40 9.06
1.4500 1.94 11.52
1.4750 0.89 14.69

Assuming that the company chooses to hedge the receipt of $ 10,000,000

Required:
Demonstrate the result if the spot rate on June 30th is
(i) $ 1.55/ ₤
(ii) $ 1.35/ ₤

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Question Six
Prices / premiums on 1 June for sterling traded currency options on the forex stock exchange are
shown in the following table

Sterling ₤ 31,250 contracts (cents per ₤)

Calls puts
Exercise price September December September December
$/₤
1.50 5.55 7.95 0.42 1.95
1.55 2.75 3.85 4.15 6.30
1.60 0.25 1.00 9.40 11.20

Prices are quoted in cents per ₤ and the current spot exchange rate is $1.5404 - $1.5425.

Stark Inc, a US company is due to receive ₤ 3,750,000 from a debtor in four month’s time at the
end of September. The treasurer decides to hedge this receipt using September ₤ traded options.

Required:
(a) Compute the results by using options hedges, illustrating the results with all three possible
option exercise prices if by the end of September, the spot exchange rate moves to
(i) $ 1.48/ ₤
(ii) $ 1.57/ ₤
(iii) $ 1.62/ ₤
(b) Suggest the best exercise price

Question Seven
Wazalendo Company specializes in supplying Tanzanian made textile products to companies in
the textile industry. Its directors are considering how best to manage the financial risk of a
receivable transaction. Details of the transactions are given below:

Transaction
It is now 03rd November 2022, and the spot rate is TZS2,430.50/₤. Apex Company, a UK trading
firm, is a new customer and its first payments to Wazalendo Company ₤62,500 is due on January
2023. Wazalendo Management is considering using either traded currency options or futures to
hedge the 01st January 2023 receipts from Apex Company. The following information has been
collected:

Prices for market traded currency options on 03rd November (Sterling 31,250) Contracts
November 2022 January 2023
Exercise price TZS/₤ Calls Puts Calls Puts
2,445 69 135 114 157
Premiums are in cent per ₤

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Sterling Future Prices for market traded currency future on 03 rd November (Sterling 62,500
Contracts)
January 2023 TZS2,434
March 2023 TZS2,438

Required:
i. Calculate TZS receivable by Wazalendo Company if, to hedge its receipts from Apex
Company, it uses: (a) Traded Currency Options, (b) Sterling Future. Assume a spot rate of
TZS2,429 ON 01st January 2023 and Futures price of TZS2,433.
ii. With reference to your calculations in part (i) above, advise Wazalendo Company´s
management how it should proceed.