APPENDIX 4A: CONTINUOUS COMPOUNDING
6.1 WHAT IS AN OPTION?
6
Currency Options and Options Markets
There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.
— Mark Twain
G
overnance of the multinational corporation involves creating and managing a wide variety of options. Options are embedded in the firm’s real assets, including options to expand, contract, suspend, or abandon the firm’s investments.Human resource management employs options as rewards in executive compensation contracts and in employment termination clauses. Options are attached to corporate securities in the form of call and convertibility options and interest rate caps and floors. Options insure the firm against property and casualty risks. Understanding how these options affect the firm is both a challenge and an opportunity for the financial manager.
Currency options are a useful tool for managing the multinational corporation’s exposures to currency risk. Currency options are derivative securities, in that their value is derived from the value of an underlying exchange rate. As exchange rates change, so do the values of options written on the exchange rate. This chapter employs simple graphs to develop the intuition behind option valuation and their use in hedging currency risks. The technical details of option valuation are presented in the appendix to the chapter.
One side has the option; the other an obligation.
Types of Currency Options
There are two types of options — calls and puts.
■ A currencycall optionis the right to buy the underlying currency at a specified price and on a specified date.
■ A currencyput optionis the right to sell the underlying currency at a specified price and on a specified date.
If you sell or writea currency call option, the buyer of the option has the right to buy one currency with another currency at the contract’s exercise price, or strike price. The option writer has the obligation to sell currency to the option holder. A currency put option holder has the right to sell a specified amount of currency at the exercise price. A currency put option writer has the obligation to buy the currency from the put option holder, should the option be exercised.
Markets in Currency Options
Currency option contracts are traded on financial exchanges, as well as over-the- counter (OTC) through commercial and investment banks.
Exchange-Traded Currency Options Currency options were first traded on an orga- nized exchange in 1983 at the Philadelphia Stock Exchange (PSE, now a part of NASDAQ OMX). Currency options now trade at a large number of derivatives exchanges around the world. Option contracts often are written on an underlying futures contract rather than on the spot exchange rate because options are more easily settled with futures contracts than with cash. Figure 6.1 shows the growth of
0 50 100 150 200
1996 1998 2000 2002 2004 2006 2008 2010
North America Outside North America
FIGURE 6.1 Exchange-Traded Currency Options Outstanding at Year-End (in $ billions).
Source:Bank for International Settlements (www.bis.org).
PSE Chicago Mercantile Exchange (CME)
“British pound Dec 145 call (European)” “British pound Dec 1450 put (American)”
Underlying asset British pound sterling British pound sterling
Type of option Call option Put option
Expiration date Third Wednesday in December Third Wednesday in December Rule for exercise European – exercisable only at expiration American – exercisable before expiration
Settlement Spot currency Nearest CME futures contract
Pounds-per-contract £31,250 £62,500
FIGURE 6.2 Currency Option Contract Terms.
exchange-traded currency options based on the end-of-the-year value of outstanding contracts. As with currency futures trading, much of the recent growth has been driven by derivatives exchanges outside of North America.
Options on spot and futures are essentially the same.
Figure 6.2 describes the contract terms of a ‘‘British pound Dec 145 call’’ traded on the PSE and a ‘‘British pound Dec 1450 put’’ from the CME. The underlying asset or deliverable instrument of the option is the currency being bought or sold.
The PSE call is an option to buy pounds. The CME put is an option to sell pounds.
PSE contracts are settled in spot currency. The deliverable instrument of the CME contract is the CME futures contract expiring one week after the expirationof the option contract. Options on spot and futures are nearly identical in their ability to hedge currency risk because futures prices converge to spot prices at expiration (see Chapter 5) and spot and futures price volatilities are nearly the same.
Each PSE contract is worth £31,250. The holder of this option has the right to buy £31,250 pounds at K$/£=$1.45/£ on the contract’s expiration date, where the symbol Kd/f is used to indicate the exercise price in domestic currency per foreign currency unit. The option holder pays £31,250($1.45/£)=$45,312.50 and receives
£31,250 upon exercise. Both PSE and CME options expire on the Saturday before the third Wednesday of the month, so the last day of trade is the previous Friday.
The third Wednesday of the month is the settlement date on which currencies are exchanged. The PSE contract is aEuropean option, exercisable only at expiration.
The CME option is an example of an American option; that is, an option that can be exercised prior to expiration. Holders of American options are usually better off if they leave their options unexercised. Because early exercise options are seldom exercised, European and American currency options are nearly equivalent in their ability to hedge currency risk.1
Over-the-Counter Currency Options Financial institutions conduct an active OTC market in currency options. Whereas exchange-traded options are standardized, OTC options are customized to fit the needs of individual customers. Expiration dates and contract amounts are specified by the customer, and prices and fees are then quoted by the bank.
OTC options are custom-tailored.
Retail clients include corporations and financial institutions that have a need to manage their currency risk exposures. These clients value the right to exercise a currency option and typically do not want the obligation from writing option contracts. International commercial and investment banks are the principal writers (sellers) of currency options. This asymmetry between buyers and sellers is not seen in currency forward and futures markets. International banks also maintain an active wholesale market in which they hedge — or reinsure — the currency risk exposures in their asset/liability portfolios.