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ACCA AFM | Foreign Currency Risks | Currency Options | Lecture 37

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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

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

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

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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