This content explains how to manage foreign exchange (FX) rate exposure using options, focusing on the perspective of an option buyer and detailing the steps involved in selecting and utilizing call and put options for hedging.
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Remember we are still looking at the
series on how to manage
FX rate exposure
and uh in the previous recording I've
spoken about how to use forward how to
use money market edge how to use
futures. Now speaking about options,
yeah, I've also spoken about options
earlier on. try to explain the basic
terminologies of options especially when
we're concluding that later part of
investment appraisal with options where
we spoke about black and a lot of
terminologies I've explained and I
believe is still very fresh with all of
that but I'm still going to make a bit
of reference to what I said earlier and
the fact is option is always a right
yeah please take note I'm going to be
explaining this in the perspective of a
buyer of an option. Remember as I said
earlier, if you are the one selling an
option, what you have is an obligation.
You don't have a right. But here we'll
be looking at it like a buyer. So a
buyer has a right. So please note that
because I know it's usually a point of
confusion for student. So right is only
to the buyer of option. And this buyer
can buy two types of option.
This guy can buy call. Either he's
And what does this mean? When you are
buying a call, what we are saying is
that you are buying
a flexibility. Yeah. a right to buy
of FX foreign currency
at a specific rate which is a strike price.
price.
That's what you call the strike price.
Likewise, if you buy a right, it means
that this guy is buying
a right
to sell
an amount
at a specific rate,
which is a strike price, right? So, just
a quick refresher. And when you are
Yeah, that's usually the price of your
option. You're going to pay a premium to
whereby selling to you. Please take
note. So, which means once you pay then
you have your flexibility. And what is
that flexibility all about? Flexibility
is just about saying that you have the
So which means on settlement date or on
the option expiry date you can actually
decide not to use it. And when will you
decide not to use it? Definitely if the
real movement the spot movement or the
reality on that day reflects that the
market is actually in your favor then
you don't have to use the option. You
can just go with the market and walk
away from the option. But if the market
has gone against you in an advanced way
then definitely the option becomes very
useful and that is when you would like
to exercise very important. Let's
quickly look at the steps.
What are the steps? Yeah, just to break
it down into a workable space for you.
So the first one is you need to be able
to decide.
You need to learn how to decide if you need
need
a call
or a put.
Very important. When do you buy a call
and when do you buy a put? Yeah, this is
very easy. What I will tell you is that
you need to always first of all know
your currency of contract. All your
interpretations must be made in your
currency of contract. Extremely
important. Yeah. And what you'll be
asking yourself is do I have to sell the
currency of contract in the future or do
I need to buy the currency of contract
in the future? You always know your
currency of contract because it will be
stated in your question as the size of
the contract. So take for instance if
they say size of the contract is $20,000
and that means the currency of contract
is in dollars. If they say the size of
contract is €10,000, that means the
currency of contract is euro. then you
need to know that your
objective now will determine whether
you're buying call or you're buying a
put. So if you're going to be selling
the currency of contract, take for
instance dollar, then you know that your
edge has to be a put. So you need to be
buying a put which means the right to
sell the dollar at a particular rate
that you're picking. And if your
currency of contract, so this is your
currency of contract. If your currency
of contract is euro, yeah, and um let's
yeah, with local currency of card.
Now if you are expecting a receipt
yeah in dollars what this means is that
you have to sell these dollars
and that means you need to use a put but
if you are going to pay dollars in the
future yeah which means
you have to sell Canadian dollars to buy
card. So because you need to buy card,
sorry, you need to buy dollar to be able
to pay this future dollars. Then you
need to be buying a call. That's the way
you're going to have the right to be
able to buy the dollar in the future. So
that's how to know the type of option
that you need. And that's your first
step that you need to know. The second
step you need to be thinking about very
important is okay, I know what I need. I
need a call or I need a put. How many of
such contract do I need?
In all your edging, you must always know
how many contracts, especially the
exchange traded options or exchange
traded instruments. Generally speaking,
what I always tell you is the fact that
you don't decide on what is available in
the market. The market will tell you
what is available. So the sizes in the
market might not exactly match what you
want. So you only most likely be able to
buy certain amount and you might always
have some amount on hedge. And please
I'm always telling you beware of on edge
portion of your exposure because those
ones must always be exchanged at the
spot rate on the on the on the
transaction date because you couldn't
edge them. There's no contract to take
care of that size. Right? So and now you
know the number of contract that you
need. What I will always tell you is
please always remember that you must
always work with currency of contract.
That's the first thing. So what you need
to do is you need to determine the
amount of
your transaction in the currency of
contract. But how do you know? You have
to use your
strike price to determine that amount is
very important. You always need to use
that strike price. Extremely extremely
important. So please remember to always
calculate the value of the transaction
in the corres of contract. So
and if you know that then it life will
be super easy for you because the number
of contract that you need will always be
please note in currency of contract
divided by the contract size.
We're going to work some examples now to quickly
quickly
explain this to you. Right. So with
this, you're going to know the number of
contracts that you need. And once you
know the number of contract that you
need, then you can select the right
expiry date for your option. Remember
your option will come in different
months. That's June option uh all sort
of options.
We don't give you September, October,
March all in one question. But you must
be able to pick what is the right date
that you should be using for your
option. It's very important. You must be
able to do that.
And I'm going to even show you what
sometimes this look like. Let me see if
Yeah, this is a very good example.
Yeah, look at this now. Right. So, you
can see you have June, you have
September, you have December, you have
all over there. So you must know whether
you want a June call or a September call
or you want
December. You must be able to pick which
one do you really want. Yeah. So if you
know the one you want, then you can pick
the right strike price. But please note
that your expiry date will always be the
date of your transaction. So you need to
always match.
date with
with option
option exercise
Remember we are focusing assumption is
that all these are European options.
they are not flexible can only be
exercised on the expiry date unlike the
American options that are flexible.
Okay. So once you know that then you
Yeah. You must be able to pick the right
strike price here. And what am I talking
about? Look at this table that I have
here. Let's look at call for June for an
example. Or it's called for June. Let's
look at this one.
If you look at this closely, you see
that we have four different strike
prices available and the premium
different as well.
Likewise, we have different for
September, December. Yeah. And put
also. So let's say we want to use a
call. If we need a call for this
transaction and this is information we
have available for us,
what strike price will be the best for
us. First thing you need to know is that
when you are talking about the call you
are buying is an option to buy. So which
means the strike price is payment. So
you pay the strike price
and in addition you're going to pay premium.
And if that is the case then you have
total things to pay. And what will be
your objective? Your objective will be
to go for the cheapest strike price. So,
cheapest net strike price that will
always be your objective. Please take
note anytime you are talking about call
your objective is to look for
a strike price that gives you the
cheapest net.
And let's look at this. So, if we look
at what we have now,
all we need to do is to deduct. No,
we're going to be hiding because both of
them are payment as you can see. Yeah.
So, if they are both payment, then that
115 plus another 1.99 that we will have
to pay because it's a call which means
the net for this is invariably
and the other one 1.39
+ 116
+ 117
and this 117.87 87
87
54. And you can see makes sense that the
strike price as the strike price is
increasing downwards
what happens to the premium? Premium
will decrease.
Yeah. Because it becomes less attractive
when the strike price is increasing
because you are telling somebody to come
and buy at a high price. So the higher
the price you expect that the premium
lower but if you look at all of these
options four options we have four
possibilities. The cheapest one for us
is the first one and that is why
definitely in this scenario 115 strike
price option will be our selection. So
we'll go for the option that has the
strike price
as 115 and we will pay a premium of
1.99. We're happy to do that.
I mean was put for put if you want to
pick the right strike price for put what
you need to look for is because this one
is an option to sell. So if your option
to sell it means that your strike price
So that's inflow. So you want this to be
as high as possible while at the same
time you still have to pay premium
because you are buying it. So which means
means
the highest will be the scenario. Now
the highest net of strike price minus
premium is what you are looking for. In
the previous example, what you are
looking for is the lowest
strike price plus premium. That's what
you're looking for. But for premium for
put, you look for the highest because if
you're buying, you want to buy at the
cheapest possible. If you are selling,
you want to make the highest money
possible. So in this uh scenario, you
will discover that if you are still
sticking on June, let's still play with June.
June.
But all this strike price and all this
option this one means that it's not
available. So not yet available. So we
only have three possibilities. So let's
see which of these puts we're going to
be using 115 inflow minus.64 that we
is 115
and 117 like that's 1.43
So 117 definitely will give us the
highest inflow possible because this is
the highest figure. This is the highest
net. Yeah. So if we talk about put then
117 the option with strike price of 117
will be our best bet. So that's how to
choose your strike price. Very important
to know that. Let's let's look at an example.
Yeah this one.
This bongo take few seconds and pause
Yeah. So look at this.
What is going on with this company? This
company will have to pay
this amount in the future. That's the
problem. Now
he needs to pay.
So pay payable
So if you have a payable of $350,000
that is not my problem. The first
problem I need to be asking myself is
what is the currency of contract? Please
remember that is always the first
question you need to ask yourself. The
currency of contract. The currency of
contract. What is the currency of
contract? In this question the currency
Which means I need to find out what
would this be in pounds for me to be
able to deal with the number of contract
that I need. But like I said, our first
step, we need to know are we using call
or are we using put so and we need to
interpret this in the currency of
contract. So if we need to pay dollars
in the future, it means that we're going
to be selling pounds now to be able to
get those dollars. So which means we're
going to be using option to sell and
that is a put. So that's the only that's
the only thing that will give us an
option to sell. So when we know that
we need a put
this is done we need how many contract
we need to buy. But before we can get
how many contract we need to buy we need
to get the volume of our transaction in
the currency of contract. So we won't be
able to do that until we know the strike
price that we should be using. So let's
quickly decide what is the strike price
that we'll be using.
We're going to be able to pick our
strike price based on the correct expiry date
date
that ties with our transaction date and
the most efficient
going to be looking for the cheapest.
So when you look at this situation we
don't have so many options of expiry
date. We are lucky we have only been
given June contract as you can see. So
there's nothing to sweat about. And if
that is the case,
then the next question is, are we using
this one or are we using this one? Since
it's a put, so we need to be looking at
this side and not this side. We don't
have any business here, right? So
what they've told us is that the premium
are actually in cent for every pound,
right? So which means the same way you
have for the quotes. The quote is $1.5
for 1.45
strike price and.124
or 1.5. So which means net that talking
about will be 1.5 inflow minus payment
of 1.102.
So that is 1.348
active for this one net. And if you go
for 1.5 strike our net price will be
So in that case this is the best for us
and this is not the so we're going to go
for 1.5 as our strike price. So we
already know that the strike price will
be 1.5. That's what we're going to go
for. So that's $1.5
for every pound. So with this we can get
our value of transaction in currency of
contract that will be equals to
remember when we say what we're saying
is that $1.5
is equals to1
and we're talking of receiving I mean we
need equivalent of $350,000.
So that will be equals to 350,000
by 1.5.
that gives us value of contract that is
equals to in pounds 2 33 3
value of transaction yeah of this
amount. So if this is our amount and we
know that each contract
they told us that it is 25,000 as you
can see
is the value of each contract £25,000.
£25,000.
So if that's in the case then we know that,000.
that we need will be equals to 2 33 33
33 3.33
/ by 25,000.
And if you do that, that will give us
9.3 contracts.
Now this is where you need to be
careful. There's no decimal place for
number of contract. So which means you
can edge it.
So we'll come back to that. The point 33
of our contract zone will be on edge
unfortunately and uh we're going to be
able to edge n contract.
Okay. So now
we are sorted. We know that um we are buying
of a call option of a put option.
with
exercise price of
one 15. Yeah. 1.45. Which one did we
choose? No, 1.5. 7.5 is the best
of I think that's uh June contract. Yes, June.
So that's what we want to buy. So
contract is set. We're ready. So we
close out this contract. We need to pay
premium. So once we know the contract
then the next thing is for us to pay the premium.
Remember you don't have a contract until
you pay your premium because it's a
premium that gives you the right to the
flexibility that you've been talking
about. Yeah. So and in that case you
need to know the number of contract you
bought and that's why it's extremely
important because without that
without the number of contract your
premium calculation might be wrong if
you don't have evenly uh distributed
contract and you're able to hedge
everything right so for the contract
that we are buying n of them we can see
that for each band we're going to be
paying a premium of $124.
per pound.
Yeah. And you know how much pounds are
we going to be getting? We are talking
of each contract is worth £25,000.
We have decided to buy nine of that and
each of the pound will attract a premium of
of 0.124.
Please remember what we are calculating
is the premium. Yeah, which is in
dollars because the premium is coded in
dollars. Don't be confused with this
band because I know it might be kind of
confusing. Remember this is just the size
size
the path symbol you are seeing here is
just to show the contract currency. This
is a notion is an amount is a is a size
amount. It's not it's not a currency
that is just size. So it's 25,000
* 9 *.124
and that will give you the total
premium of $27,900.
So we need to pay this premium on day
on a one
But remember, we are not a US company.
We are UK company. So we don't even have
this $27,000.
So which means we need to look for it.
And what does it mean? We need to buy it
at spot. So we have to buy 27,900
So we need the spot rate and let's see
whether we have it in the question.
Yeah. So they give us the spot as you
can see it said the currency dollar spot
trait is this. So remember I always tell
you you need to know how to pick whether
this one or this one. And what you need
to ask yourself is whether is a bid or
ask price that you're going to be using.
It depends on what you are doing to the
second currency and what the bank is
doing to the second currency. So think
bank, think second currency.
You want to buy dollars which means you
are selling pounds. If you are selling
pound, bank must be buying the pounds
from you. So automatically you have to
use the buy rate and not the ask the
selling rate.
Yeah, by now you should be used to that
interpretation. So, which means the rate
So the equivalent in pounds that we're
/ 1.5190
and that will give us in pounds let's
see by 1.51
90 that's 18, 367.35.
So this is the premium that we have to
pay now and once we pay that then we
have a contract we can go and sleep and
wait for the expiry date. So
on settlement date when the due date comes
comes
which means date of expiry of the of the
option this is the day we need to decide
whether we want to exercise or we don't
want to exercise. How do you decide? You
Those are the two things you need to
check. And based on your condition, you
decide which one is better for you.
Currently, your strike price is 1.5.
That's what you've agreed. So, you agree
to sell $1.5 for £1.
But sport what is spot on that day is
saying they gave us spot on that day
under the required thing they said this
is the spot
gave us spot said
on
that's on the 30th of June. So remember
on the spot what are we going to be
doing because we're going to pay dollar.
So we will be selling pounds on that
spot day that we are selling pounds bank
will be buying it from us. So it's this
buying rate that will be applicable to
us if we need to compare now. So let's
compare with 1.1 and 1.5 and decide
which one we're going to look for. So 1.4
1.4 810
for every pound. So what we know is that
we are we are selling pound. So do we
prefer to sell pounds for $1.5 or sell
it for 1.4 dollar? Definitely
it is better to sell for 1.5 because we
will be able to get more dollar because
dollar that we need right so which means
very important to know that and once we
exercise it means that we're going to be
buying our nine contract that is
equivalent to 25,000
and that will be giving us a total pound
of 225 5,000.
So we collect our contract. Yeah. But
remember this is the contract that we
bought. So we get this £225,000
which means we have exercised at a 1.5.
That's why we to get this 225. Yeah.
However, there's a portion that we were
not able to edge. If you remember,
there's a portion that we couldn't edge.
And why we couldn't edge it? Because the
contract size doesn't allow us. We're
not able to do that because of the
contract size.
And the question is, how do you deal
with that?
Remember what I said that particular one
you must convert it at the
spot rate cuz we only bought nine
contract. So the nine cr the nine
contract that we bought we bought at $1.5
$1.5
for each pound.
from the contract.
So we can know how much dollars we've
been able to sell to to be able to get
So which means we must have been able to
sell a dollar that is equivalent to 1.5
* 225.
So so total dollars sold
or bought because we're actually paying.
We're buying
the total amount of dollar purchased
will be equals to 1.5
which means we've been able to purchase 337
337 $500
because that's coming from our edge
because this is the size of our contract
we have exercised at 1.5. Yeah, we said
we exercise. So when we exercise at 1.5
they automatically counterparty will
give us this amount of dollars but we
still have some left that we need
because we needed total sum of $350.
That is all we need $350,000.
more dollar needed because
because
we couldn't edge everything. So that
minus 350,000.
So which means we needed a dollar worth
of 12,500.
So this one we don't have any other
option. We have to buy it at the spot
rate. The spot rate is we decided on
that already is 1.4. 481
for each pound. So which means we're
going to get 12,500.
12,500.
We need this amount of pounds to be able to
to
pay our
debt. So that will be equals to in
pounds we need to cover this money.
So which mean invariably the total
pounds that we need to do this
transaction will be 225,000 that we got
from edging plus 8440
that we got
that we have to use
for the on edge portion this one edging
help us this one from on edge and also
we paid a premium remember we paid a
premium of I see of this amount to be
able to do this agent transaction. So 18367.35
So these three items were the total
amount that we used in pounds to be able
to pay our £350,000
that we have to pay someone. And that
cost us uh £251,000 87.
And that is it for that question.
Very important. Please take note how
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