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Currency Options – An alternative to manage FX  risk

PROTECTING EXPORT COST WITH  BUY PUT OPTION

Date : 11 January 2021

Companies in business of export and import are exposed to currency risk. It is wise to protect the cost of transaction against currency fluctuations. Companies can mitigate currency fluctuation risk by Futures and Options. Normally most of the companies do not have access to banks for managing risk through options but trading platforms like BSE currency permits use of options as a tool to manage currency risk without any restrictions.

Options provide three key benefits –

  • It is cost efficient
  • It is more efficient in risk management than currency futures
  • It is a strategic alternative to currency futures

A currency option is a contract that gives buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. On expiry date, if option contracts are not utilized then only premium amount is at loss. Importers/ Exporters can hedge against foreign currency risk by purchasing a currency put or call. Currency options are derivatives based on underlying currency pairs. Risk includes interest rate differentials (IRD), market volatility, the time horizon for expiration, and the current price of the currency pair.

BENEFITS

  1. Option limits the downside risk and may lose only the premium paid to buy the options, but have unlimited upside potential.
  2. Options will hedge open positions which Exporter/ Importer can hold in the forex cash market.

KEY OPTION TERMINOLOGY

Premium – The upfront cost of purchasing a currency exchange option.

Strike Price – The strike (or exercise price) is the price at which the option holder has the right to buy or sell a currency.

Expiry Date – The trade’s expiry date is the last date on which the rights attached to an option may be exercised.

Exercise – The act of the option buyer notifying the seller that they intend to utilize  the option contract.

Delivery Date – The date when the currency exchange will take place, if the option is exercised.

CASE STUDY

Mr. Bharat is a garment exporter. He gets a contract to supply 10,000 shirts to USA in the month of January 2021.The cost of making one shirt is Rs 72.50. He keeps a  profit margin of 50 paisa. Thereby making the final cost per shirt as Rs 73. Remittance is expected in the month of February.

The current rate (spot rate) is 73.00 and one month future currency is 73.20. If he books BSE future contract then he will get a profit of 20 paisa. In this case if dollar rupee goes above 73.20, he will not be able to take advantage of favorable market movement hence Mr. Bharat decides to use put option.

For 27 Jan 2021 expiry, premium of 73.75 strike is 0.18 and premium level of 73.50 strike is 0.11

He can BUY either 73.75 PUT by paying 0.18 paise or 73.75 PUT by paying 0.11 paise

Cash Flows for 73.75 strike

RateOption ExercisedOption P & LBank P & LNet P & L
72.50Yes1.25 – 0.18 = 1.0772.50 – 73.00 = – 0.500.57
73.00Yes0.75 – 0.18 = 0.5773.00 – 73.00 = 0.000.57
73.50Yes0.25 – 0.18 = 0.0773.50 – 73.00 = 0.500.57
74.00No0.00 – 0.18 = – 0.1874.00 – 73.00 = 1.000.82
74.50No0.00 – 0.18 = – 0.1874.50 – 73.00 = 1.501.32
75.00No0.00 – 0.18 = – 0.1875.00 – 73.00 = 2.001.82

 

Cash Flows for 73.50 strike

RateOption ExercisedOption P & LBank P & LNet P & L
72.50Yes1.00 – 0.11 = 0.8972.50 – 73.00 = – 0.500.39
73.00Yes0.50 – 0.11 = 0.3973.00 – 73.00 = 0.000.39
73.50No0.00 – 0.11 = – 0.1173.50 – 73.00 = 0.500.39
74.00No0.00 – 0.11 = – 0.1174.00 – 73.00 = 1.000.89
74.50No0.00 – 0.11 = – 0.1174.50 – 73.00 = 1.501.39
75.00No0.00 – 0.11 = – 0.1175.00 – 73.00 = 2.001.89

 

Conclusion

We can conclude that BSE Currency options is also an option to hedge the Currency Risk for an exporter. The downside risk is well protected and the exporter can also take advantage if the market moves in his favour ie Dollar Rupee starts going up.