# Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 42
FOREIGN EXCHANGE MARKET'S OPTIONS
How options work?
Exercising the option
Calculating gains on options
Currency options
Hedging with currency options
How Options Work?
Options are also used to reduce the risk of unfavorable price movements in stocks or share, or any
commodity. In other words, the investor is trying to fix the price of the commodity or stock by trading
now. Therefore, the first objective of using options is to eliminate the risk of adverse price movement.
However, there may be some gain on this transaction with some chances of loss as well.
In order to understand how option actually works, we take up the following example and see what factors
we need to consider when we are going to exercise the option:
An investor buys 20 options on shares of xyz ltd at a price of Rs 500 (per share). Each option consists of
100 shares and premium paid is Rs. 5/- per share. What will happen if, at the expiry of option, the share
price is?
i) 516 or
ii) 490?
Looking at the example, the investor is trying to hedge the adverse price movement of that particular stock
in near future. He may not have the funds right now and expects to receive the same in near future so he is
interest in "arresting" the price now by buying an option. However, this is going to cost.
You can see that there is Rs. 5/per share as option cost. If the investor does not exercise the option, he
must bear this in mind that "this cost" will represent the loss. In options, the loss is normally the amount
that has been paid as option cost.
Now the question is "under what circumstances" the investor will exercise the option. The investor and the
option seller have agreed over a price of Rs 500/ per share meaning that the investor will buy the agreed
number of shares from the option seller for this per share amount, regardless of what per share cost actually
prevail in the market on that date if date is falling within the terms of agreement.
Decision Rule:
If on or before the expiry date, the price of share is greater than the agreed rate of Rs. 500 per share, then
the investor will exercise it right to buy stipulated number of shares from the option seller. Nevertheless,
the cost factor should also be considered by deducting the cost per share from the prevalent price of the
share on the exercising date.
Calculations of gain and loss:
Now if the share price, per first scenario, is Rs. 516, which is significantly above the agreed price of Rs. 500
per share, the option should be exercised. This is because at present this particular stock is being traded at
Rs. 516 per share whereas the investor will get the same for Rs. 500 per share ­ the agreed price. This
results in a gain of Rs. 16 per share and the total gain would be Rs 16 per share multiplied by total number
of shares. Remember this will be gross gain and we need to subtract the option cost of Rs 5 per share to
reach at net gain.
Now consider the other scenario. If the market price of share in question is Rs. 490 per share, the question
will be "is there any benefit in exercising the option?"
No is the answer. Why? Look the market price of that stock now is Rs. 490 per share and that means that
investor can buy it cheap from the market instead of buying form the option seller for Rs. 500 per share. In
this situation, the investor is not going to exercise it and the cost paid as option fee represents the loss to
the investor and gain to the option seller.
In both the situations we can easily sum up that loss of one party is the gain of other party. This is called
zero sum game. Take the second scenario the investor is confront with the loss in terms of cost of option.
The total loss is the cost of Rs. 5 per share multiplied by total number of shares (Rs. 10,000), which is the
gain of the option seller.
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Corporate Finance ­FIN 622
VU
Currency Options:
Currency option is a contract like equity options that we have covered in previous section. This is a
contract, which confers right to the buyer to buy or sell (but not obligation) a fixed amount of underlying
currency at a fixed price (strike price) on a fixed date (expiry).
Amount of underlying currency is governed by the contract size as determined in each currency. A buyer of
a call option has a right but not the obligation to buy the underlying currency. A buyer of a put option has a
right but not the obligation to sell the underlying currency. Premium is charged by option writer from
option holder.
Hedging with Currency Option:
To construct a hedge with currency option, one needs to consider the following:
The extent of exposure and the currency involved ­ future receipt and payment to be determined.
Consider the hedging tool ­ a call or put option will serve the purpose.
Calculate the most suitable strike price out of several available.
Option will be only exercised if it is in the money and buy or sell the currency at the strike price.
Alternatively, let the option lapse if it is out of money. Progress
Interest Rate Options:
An investment tool whose payoff depends on the future level of interest rates. Interest rate options are both
An interest rate option carries a notional amount of principal, which means that it is not the actual amount
to be taken out from a account. It is used to calculate the terminal gain or loss calculation. This aspect of
interest rate options is similar to FRAs and short-term interest rate futures. Such options are either over the
If the option is exercised, it is cash settled. The strike rate for the option is compared with an agreed
benchmark rate of interest. Benchmark rate may be KIBOR. (Karachi Inter Bank Offered Rate)
For example, a firm buys a borrowers' option in February to borrow a notional amount of Rs. 5 million on
May 31 for three months at interest rate of 5% per annum. A premium is charged for the option.
At the expiry of three months, the benchmark rate may be higher than the strike rate of 5%. If so, the
borrower's option is in the money and will be exercised. However, the option holder does not receive a
three-month loan at 5%. Instead, it will borrow the money it needs at the prevailing market rate. The option
seller must make a cash payment to the option holder for the difference between the benchmark and strike
rate at the expiry date.
And if at expiry, the three-month benchmark rate is lower than the strike rate of 5% then the borrower's
option is out of the money and the option will not be exercised. The company will borrow the money it
needs in the market at the prevailing rate.
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