BSE CURRENCY OPTIONS
Protecting Importer’s cost with BUY CALL option
Date : 18 January 2021
Call options are a type of derivative contracts that give holder the right, but not the obligation to purchase a specified amount of Currency at a predetermined price, known as the “strike price” of the option. If the Currency rate rises above the option’s strike price, the option holder can exercise it, buying at the strike price and selling at the higher market price in order to lock in a profit. If the market price does not rise above the strike price during that period the options expires worthless.
OPTION TERMINOLOGY
- Premium – The upfront cost of purchasing a currency exchange option is known as premium. It is paid by the buyer to the seller of the 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 expiry date of trade is the last date on which the rights attached to an option may be exercised.
- Hedging: Hedging is a strategy to decrease or transfer risk in order to protect one’s portfolio / business from uncertainty in prices. In case of hedging in the foreign exchange market, the intention is to protect the underlying exposure from an unexpected currency move.
- Trading Hour: The trading hours are from 9 a.m. to 5.00 p.m. on all working days from Monday to Friday and the contract Size is US$ 1,000.
- Settlement Price: The final settlement price is the RBI USD-INR Reference Rate on the date of expiry of the contracts.
CASE STUDY:
M/s Bharat Steels gets a contract to supply 1000 tons of steel in India. He has to import it from Japan. The cost of steel is $ 600 per ton. His total exposure is $ 600,000. The current rate is 73.00 which is spot rate and future rate is 73.15. Costing of steel in domestic country is approx. 73.75, keeping a profit margin of 75 paisa.
The current rate (spot rate) is 73.00 and one month future currency is 73.15. If he books BSE future contract then he will get a profit of (73.75 – 73.15) 60 paisa. In this case if dollar rupee goes below 73.15, he will not be able to take advantage of favorable market movement hence Mr. Bharat decides to use call option to mitigate the risk.
CASES :
For 27 Jan 2021 expiry, premium of 73.50 strike is 0.09 and premium level of 73.25 strike is 0.16
Option 1 : Buy 73.50 Call at 0.09
Option 2 : Buy 73.25 call at 0.16
Cash Flows – Option Strike 73.50
| Rate | Option Exercised | Option P & L | Bank P & L | Net P & L | |
| 72.50 | No | -0.09 | 1.25 | 1.16 | |
| 73.00 | No | -0.09 | 0.75 | 0.66 | |
| 73.50 | No | -0.09 | 0.25 | 0.16 | |
| 74.00 | Yes | =74.00 – 73.50 – 0.09 | 0.41 | -0.25 | 0.16 |
| 74.50 | Yes | =74.50 – 73.50 – 0.09 | 0.91 | -0.75 | 0.16 |
| 75.00 | Yes | =75.00 – 73.50 – 0.09 | 1.41 | -1.25 | 0.16 |
Cash Flows – Option Strike 73.25
| Rate | Option Exercised | Option P & L | Bank P & L | Net P & L | |
| 72.50 | No | -0.16 | 1.25 | 1.09 | |
| 73.00 | No | -0.16 | 0.75 | 0.59 | |
| 73.50 | Yes | =73.50 – 73.25 – 0.16 | 0.09 | 0.25 | 0.34 |
| 74.00 | Yes | =74.00 – 73.25 – 0.16 | 0.59 | -0.25 | 0.34 |
| 74.50 | Yes | =74.50 – 73.50 – 0.09 | 1.09 | -0.75 | 0.34 |
| 75.00 | Yes | =75.00 – 73.50 – 0.09 | 1.59 | -1.25 | 0.34 |
CONCLUSION
Thus we conclude that BSE Currency options are an option to hedge the Currency Risk for an Importer. The upside risk is well protected and the Importer can also take advantage if the market moves in his favour ie. Dollar Rupee goes down.
©Prashanti Forex
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