CONCLUDING REMARKS

7 Purposes

7.10 CONCLUDING REMARKS

Today, there are products available in the foreign exchange market, which can address all types of foreign exchange exposures and purposes. As mentioned in an earlier chapter, there are six

basic foreign exchange products:

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Spot transactions;

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Forward contracts;

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Foreign exchange swaps;

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Currency swaps;

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Currency options; and

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Foreign exchange futures contracts.

8

Applications of Currency Options

The users of the option market are widespread and varied, but the main users are organisa- tions whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers, where the standardisation of options contracts promotes tradability, but this is at the expense of flexibility.

In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options as a means to managing currency exposures. Some clients consider options to be expensive and/or spec- ulative. When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimise downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option, instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements.

Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.

Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.

Hence, in buying a currency option, it may help the purchaser by:

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Limiting downside currency fluctuation risk while retaining upside potential;

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Providing unlimited potential for gain;

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Providing a hedge for a contingent risk; and

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Enable planning with more certainty.

Selling currency options may assist the writer (seller) by:

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Providing immediate income from the premium received; and

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Providing flexibility when used with other tools as part of an exchange rate strategy.

For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By buying a call (the right to buy) the maximum cost can be fixed for a purchase and by purchasing a put (the right to sell) the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavourable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the

hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favourable moves.

In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from expecting volatility either to increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of $/sfr 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months’ time.

The trader has two choices:

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To hold the option to expiry and if the spot rate has risen to, for example, $/sfr 1.73, the trader would exercise his right to buy dollars and sell Swiss francs at 1.6835, and hence, make money. If the spot rate is below $/sfr 1.6835 at expiry, then the maximum loss is limited to the premium paid for the option.

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Alternatively, if the spot rate rises, say one month after the trader has purchased the option, the trader could choose to sell the option back. By doing this, the trader will recoup both the time value and intrinsic value of the option.

9

Users of Currency Options

There is one very important factor to remember regarding currency options, in that for the buyer of an option, the maximum risk is limited to the premium paid, while for the option seller, the maximum profit is limited to the premium received and the seller is potentially exposed to unlimited losses. Additionally, because of the credit risk involved when writing options, typically there are fewer restrictions upon those wishing to buy options than those who wish to sell.

Writing options on exchanges tends to be simpler as the credit risks are controlled by a margin system. The margin is a small percentage of the value of the contract, which must be deposited to cover losses up to a certain limit. The margin is usually adjusted on each trading day and occasionally more frequently to take account of market movements. How- ever, the greater flexibility available in the OTC market allows some of the credit difficulties to be pursued and overcome. Participants in the foreign exchange currency options market include:

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Banks – who provide a service for their clients, to manage their own foreign exchange risk, and in order to take a directional and/or volatility view.

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Supranationals and sovereigns – all issuers of debt in foreign currencies will have exchange rate exposure, which must be managed.

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Multinational companies – multinationals and their subsidiaries will have funds and cross- border transactions in several currencies and so will be subject to foreign exchange risk.

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Importers and exporters – any company that imports or exports goods to a foreign country will have exposure to fluctuations in exchange rates.

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Investors in foreign currency securities – investors in foreign securities will be exposed to fluctuations in the currency in which the securities are denominated.

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High net worth individuals – such individuals may use exchange-traded currency options for speculation on exchange rates because of the gearing they offer.