"Currency Futures and Options"- International finance -4

Others 1969 views 4 replies

Guest

Currency Futures and Options

Introduction

Foreign currencies are traded in both forward and futures markets in all the developed countries. But in India, in the absence of a regulated currency futures market, there is only a forward market and that too mainly for the dollar/ rupee. Forward rates for other currencies are based on the cross rates of dollar/ rupee and dollar/ other currencies. Forward markets for foreign currencies have been in existence for a long time all over the world, but the foreign exchange futures market developed only in the early 1970s, with trading beginning on 16 May 1972 on the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME). The presence of a strong and successful forward market retarded the development of a futures market for foreign exchange. In this dual market system, the futures market cannot exist in isolation from the forward market. The forward markets in currencies still continue to be larger than futures markets. Many traders are active in both the markets. Cash-carry and reverse cash-carry arbitrage strategies ensure that proper price relationship is maintained between the two markets.

In the forward market, the specific need of a hedger can be attended to, including the exact amount of exposure period etc. A standardised futures contract, however, can provide a hedger up to the nearest value and period. Since most of the operators are international banks and financial institutions, the forward market in this segment has grown more than the futures market.

The most important factors determining the exchange rates between the two currencies are the exchange rate regimes (fixed versus floating rates), the question of devaluation and the influence of the balance of payments. Against this institutional background, a no-arbitrage price relationship such as interest rate parity theorem (IRP) and the purchasing power parity theorem (PPP) are discussed in this chapter. These models essentially express the pricing relationship of the cost-of-carry model.

A major impetus to futures in foreign exchange was given by the end of fixed exchange rates and the widespread acceptance of floating rates, which increased exchange rate volatility dramatically and therefore increased exchange rate risk. A fixed exchange rate exists when a currency's value is fixed relative to other currencies. Intervention by the central bank is usually needed to maintain a fixed rate. In the floating exchange rate system, the values of currencies are permitted to fluctuate freely in response to demand and supply.

FOREIGN CURRENCY FUTURES

In the international market, futures trade on seven currencies visa-vis the US dollar is conducted. These are the Australian dollar, the British pound, the euro, the Canadian dollar, the Japanese yen and the Swiss franc. About 29 million currency futures contracts were traded on the US exchange in 1990, accounting for about 10 percent of all futures trading, in the US. These contracts are similar to one another, the major difference being the quantity of currency represented by one futures contract. These range from 62,500 British pounds to 12,500,000 Japanese yen. In dollar terms, almost all contracts have a value ranging between $78,000 and $120,000. The following table shows the specifications of the most active currency futures contracts:

	Pounds	Canadian dollars	Japanese Yen	Swiss franc	Australian dollars
Trading unit	62,500	100,000	12,500,000	125,000	100,000
Minimum price change	$12.50	$10		$12.5	$10
Price limit	none	none	none	none	none
Contracts months	March, June, September , December

Futures Price Quotations

Futures price quotations are published regularly in financial journals such as the Wall Street Journal. They display for each contract the open, high, low, settlement price for the day as well as the open interest. The currency quotations also include the high and low lifetime prices for each contract. In addition, an estimated total trading volume for the current day, the actual trading volume and the total open interest for the previous day are given. The different contract months and currency quotations are shown in separate rows.

Like other futures contracts, currency futures prices have a cash and carry relationship with spot exchange rates. In other words, the futures price converges to the spot price on the last futures trading day as the net carrying cost becomes zero. Thus, the theoretical currency futures price is the price at which a profitable cash and carry (or reverse cash and carry) currency arbitrage (one purchases the foreign currency at time '0' and carries it from 0 to t and then sells it at time t at a price locked in by a short futures position acquired at time 0) does not exist. This is like buying a commodity at time '0', holding it from time 0 to t, and selling it at a price locked in with a short commodity futures position at time '0'. In the case of foreign currency, the cost of carry is basically the interest on the funds borrowed for buying the currency minus the interest income earned on investing in the foreign currency. Thus, the net cost of carry would be the interest rate differential between the local market and the foreign market. This theoretical futures price is a function of the prevailing spot exchange rate and the relative local and foreign interest rates.

December prices, he can trade between the spread of these two contracts. He can sell September futures and buy December futures. Speculation with spread is with limited risk compared to outright speculation.

Hedging with the Currency Futures

The advantages of derivative products emanate from the flexibility they have in providing the hedge to the persons who have exchange exposure. We know that exports and imports are exposed to the currency risk. This exposure can be hedged through the derivatives like futures, options, etc. Futures are one of the derivatives where an exporters and importers can hedge their positions by selling or buying the futures. Since the futures market does not require upfront premium for entering into the contract as in the case of options, it provides a cost-effective way for hedging the exchange risk. The basic advantage of using currency futures is that it provides a means to hedge the trader’s position or anybody who wishes to lock-in exchange rates on future currency transactions. By purchasing (long hedge) or selling (short hedge) foreign exchange futures a corporate or an individual can fix the incoming and outgoing cash flows in one currency with respect to another currency. Anyone who is dealing with a foreign currency is faced with an exchange risk since the cash flows in terms of domestic currency are known only at the time of conversion. The objective of avoiding exchange risk can be achieved by using different tools including futures. A person who is long or expected to be long in a foreign currency will have to sell the same on a given day. A hedge can be obtained now by selling futures in that currency against the domestic currency. Similarly, a person who is short or expected to be short in a foreign currency will have to go long on the same on a given day. A hedge can be obtained now by buying futures in that currency against the domestic currency instead of buying the currency later in the spot market. However, the major disadvantage in foreign exchange futures is that, they are limited to a few currencies only. The following illustration explains how a US exporter, using futures, hedges his Euro inflows.

Illustration 4.1

Assume that a US exporter is exporting goods to his German client. On September 14, the exporter got the confirmation from the German importer that the payment of Euro 625,000 will be made on November 1, 1998. Here the US exporter is exposed to the risk due to currency fluctuations. If the Euro depreciates there will be loss on his dollar receivables. To cover this risk the exporter can sell Euro futures contract on the CME. The following working explains how the exporter is hedged.

September 14

Spot Market

Exporter gets confirmation of receivables equal to Euro 625,000 on November 1.

Spot rate is $/ 0.5900; Expected cash inflows are $3,68,750 i.e. 625,000 x 0.5900 if he were able to convert Euro to US dollars. But he cannot do so since he did not receive the Euro. However, he can go to futures market and sell futures in Euro.

Futures Market

Sell five December Euro futures contracts, since size of each contract is 125,000, at the rate which is prevailing in the market. Let the rate be $/Euro 0.6000. Hence, the equivalent notional amount in Dollars will be $3,75,000 (i.e. 0.6000 x Euro625,000).

Replies (4)

Guest

November 1

Spot Market

Dollar has appreciated and spot exchange rate is 0.5400. The dollar value of Euro625,000 now is $3,37,500.

Loss on spot market position

= $3,68,750 – $3,37,500 = $31,250

Futures Market

Buy five December Euro futures contracts. The quantity of futures contracts bought should be same as that sold on September 14. Let the futures rate be 0.5500. This gives the exporter the notional right to buy 6,25,000 by paying $3,43,750 i.e. 6,25,000 x 0.5500.

Profit on futures contracts = $3,75,000 – $34,33,750 = $31,250.

The loss in the spot market, arising from the appreciation of dollar, is offset by the profit in the futures market. In the above illustration the exporter received the same amount of US dollars as if he had sold Euro in the market on September 14, 1998. This is because the change in the rate of Euro during the period and the change in the price of futures during the same period are equal.

Spot Price (t₀) – Spot Price (t₁) = 0.5900 – 0.5400 = 0.05

Futures Price (t₀) – Futures Price (t₁) = 0.6000 – 0.5500 = 0.05

The difference between spot price and futures price is known as basis. The basis at time in the above illustration is 0.1000 and the basis at time is also 0.1000;

Date	Spot	Futures	Basis
14 Sep., 1998	0.5900	0.6000	–0.1000
01 Nov., 1999	0.5400	0.5900	–0.1000

We observe that the basis remained unchanged. When the basis remains unchanged, the gain/loss in spot market matches with the loss/gain in futures market and hence the amounts are exactly offset. However, it is unlikely that the basis remains the same through out the period.

Illustration 4.2

In the above illustration, we have seen that the rate in the futures market moved in line with that in the spot market, and absolute price change is equal in both markets. However, the change in futures rate need not be equal to the change in the spot exchange rate. If the spot and futures rates change by different amounts, there will be a change in the basis. Due to this, a degree of imperfection enters the hedge. This situation is explained in this illustration, which is different from the earlier illustration only in the assumption that the rate of exchange for December futures would be 1Euro = $0.5700 rather than 1Euro = $0.5500. Due to this the basis changes from 0.1000 to $0.3000 and, as a result, the hedge will not be perfect.

Date	Spot	Futures	Basis
14 Sep., 1998	0.5900	0.6000	0.1000
01 Nov., 1999	0.5400	0.5700	0.3000

The change in basis results in a net gain of $12500 (i.e. $31,250 – $18,750). Hence, the hedge is only partially successful. The hedger replaces outright risk with basis risk and consequently brings down the loss from $31,250 to $12,500.

September 14, 1998

Spot Market

Exporter gets confirmation of receivables equal to Euro 625,000 on November, 1.

Spot rate is 0.5900; Expected cash inflows are $3,68,750 i.e. Euro5 x 125,000 x 0.5900 if he were able to convert Euro to US dollars. But he cannot do so since he did not receive the Euro. However, he can go to futures market and sell futures in Euro.

Futures Market

Sell five December Euro futures contracts. Size of each contract would be 125,000 at the exchange rate which is prevailing in the market. The rate is 0.6000. Hence the equivalent notional amount in dollars will be $3,75,000 (i.e. 0.6000 x 5 x 125,000).

November 1, 1998

Spot Market

Dollar has appreciated and spot exchange rate is 0.5400. The dollar value of 625,000 now is $3,37,500.

Loss on spot market position = $3,68,750 – $3,37,500

= $31,250.

Futures Market

Buy five December Euro futures contracts. The quantity of futures contracts bought will be the same as that of sale. The buying rate is 0.5700. This gives the exporter the notional right to buy 6,25,000 by paying $3,56,250 i.e. 5 x 125,000 x 0.5700.

Profit on futures contracts = $3,75,000 – $3,56,250 = $18,750.

In the above illustration we have seen that the Euro inflows are being hedged by using Euro futures. This type of hedge is called direct currency hedge. A direct currency hedge involves the two currencies which are directly involved in the transaction. Thus, an Indian firm, which has a dollar payable maturing after three months may buy dollar futures, priced in terms of rupees or sell rupee futures priced in terms of dollars. If such futures are not available, a cross hedge can be used. Let us assume that the rupee and sterling movements are strongly interlinked. In that case, the firm can buy dollar futures priced in terms of sterling or sell sterling futures priced in terms of dollars. For a cross hedge to be effective, the firm has to choose a contract on an underlying currency which is almost perfectly correlated with the exposure which is being hedged. This effectively means that dollar exposure is converted to a sterling exposure.

Determining the Effective Price Using Futures

Let Sp₁ be the spot price at time T₁

Sp₂ be the spot price at time T₂

Ft₁ be the futures price at time T₁

Ft₂ be the futures price at time T₂

Sp₁ – Ft₁ = Basis at T₁

Sp₂ – Ft₂ = Basis at T₂

In the earlier illustration US exporter hedged Euro receivables by selling futures on Euro. Let us assume that the transaction has taken place at T₁ and closed at T₂. Profits made in futures markets by closing out position at T₂ = Ft₁ – Ft₂ (of course, this represents a loss if Ft₁ < Ft₂).

Price received for asset while selling in the spot market = Sp₂

Which implies, the effective price at which the US exporter sold the Euro is

= Sp₂ + (Ft₁ – Ft₂)

= Ft₁ + (Sp₂ – Ft₂)

= Ft₁ + b₂

where b₂ represents basis at time t₂

Since b₂ isunknown, the futures transaction is exposed to basis risk. If b₂ = b₁, then the effective price at which Euro sold will be Ft₁ + Sp₁ – Ft₁ = Sp₁. Due to this the risk is completely eliminated and the dollars inflows will be at today’s spot price.

Hedge Ratio

A hedger has to determine the number of futures contracts that provide best hedge for his/her risk-return profile. The hedge ratio allows the hedger to determine the number of contracts that must be employed in order to minimize the risk of the combined cash-futures position. We can define hedge ratio “as the number of futures contracts to hold for a given position in the underlying asset”.

HR =

In illustration 11.1 we considered that US exporter will hedge 625,000 receivables by selling 5 contracts on Euro futures i.e. 5 x 125,000. In that case, the hedge ratio is 1.0. The hedge ratio 1.0 will give perfect hedge when there is no change in the basis. The loss on the underlying asset position is offset by profit on the futures position and vice versa. In illustration 11.2, we mentioned that when the US exporter took a short position on 5 contracts, he made a profit on the futures position which was less than the loss on the spot position. This resulted in an imperfect hedge. Had the US exporter taken a short position on 8.33333 contracts he would have got perfect hedge.

Speculation Using Futures

Speculation differs from hedging in the sense that the basic objective of speculation is to capitalize on the difference between the expectation of speculator and that of the market. Speculation using futures can be of two types: open position trading and spread trading. When a speculator is betting on the price movements associated with a particular contract, it is called open position trading. When the speculator is trying to take advantage of movements in the price differentials between two separate futures contracts, it is called spread trading. An open position is relatively a riskier proposition than spread trading since in the former the speculator takes either a long or short position in any one contract whereas in a spread trading the speculator takes both long and short position in different contracts. Hence the risk involved in open position is higher than in spread position. We shall see some examples for both types of trading strategies in the following sections.

Pricing of Currency Futures

Pricing of the currency futures also follows the cost-carry-relationship, but in a different way. The assets which are being purchased and sold are currencies, interest rates for both the currencies determine the cost-carry-relationship. A theoretical currency futures price will be the price at which a profitable cash and carry arbitrage does not exist, more specifically, it will be where a covered interest rate arbitrage is not profitable.

Hence a currency futures price depends on the prevailing spot rate of exchange and interest rates of both the currencies concerned.

Example: On June 20, the 3-month interest rates in the US and Canada are 5.7% p.a. and 3.5% p.a. respectively. The $/Can$ Spot price is 0.6560. The theoretical futures price of September Can$ futures contract (delivery is on September 18) will be as follows:

USr                =     5.7%       p.a.
Can$              =     3.5%       p.a.
Sp $/Can$     = 0.6560

T = 91 (days)

Futures price = S x

= 0.6560 x

= 0.6560 x 1.0054 = 0.6595

Currency Futures Market in India - Future Prospects

The foreign exchange market has been strictly regulated in India. The RBI used to monitor and maintain foreign exchange rates within a particular range of values. Demand and supply of foreign currency became relevant after the Liberalized Exchange Rate Mechanism (LERMS) started in 1992. The US dollar became the intervening currency in place of the pound sterling. Today, more than 80 percent of India's foreign trade is denominated in US dollars. Now there is a floating exchange rate in India, which is determined by market forces. The RBI intervenes in the market at times to give proper direction to the exchange rate or to curb speculative volatility. The rupee has been convertible on current account since 1993, which means that there is no restriction on foreign exchange for trade and other current account transactions. However, capital account

Guest

transactions like FDI, investments abroad, borrowings in international markets etc are still regulated. The Tarapore committee, set up to study capital account convertibility, has suggested that certain milestones have to be crossed before permitting capital account convertibility. These include NPA of banks to be less than 5 percent, fiscal deficit to be contained to 3.5 percent, etc. This process was further delayed with the currency crisis in south-east Asia. Though we have sufficient foreign exchange reserves, enough to take care of eight months' imports, the government and the RBI are being cautious as far as capital account convertibility is concerned.

Exchange rate fluctuations started the moment LERMS was introduced. From 1992 to 1994, the exchange rate was more or less stable, with the dollar quoted at Rs 31.37. However, it witnessed sharp volatility after that. In February 1996, the rupee plunged to Rs 38.40 in just five-six days before it stabilized at around Rs 35. This volatility forced importers, exporters and other corporates that had an exposure in the foreign exchange to take forward cover. The forward premium on the dollar used to be more than Re 1 for 3-6 months' forward. Since the volatility was not in a particular direction, both buyers and sellers of dollars in forward had to cover their exposures. This increased the costs of businesses that had international exposures.

In USA, all futures markets are regulated by the Commodities Futures Trade Commission (CFTC). The currency futures market is also regulated by the CFTC. The cash market for currency is under the jurisdiction of the Federal Reserve. This could be because the aim of the cash market is to create securities, whereas the futures market serves the purpose of price discovery and hedging. In India, no such regulatory authority exists for the futures market. The RBI is to take active steps to create a futures market in currencies. It might be difficult for the futures market to pick up immediately in India in the face of the large number of controls and restrictions, but nevertheless, a beginning has to be made. Initially, authorised dealers (whose number exceeds 100), with some forex brokers etc., can be made the members of such a futures exchange, which can provide futures contracts in major currencies like the US dollar, the Japanese yen, the euro etc. Futures contracts up to one year can be permitted on the lines of the IMM. This will not only provide a cost-effective hedge to Indian importers, exporters and corporates, it will also provide a platform for capital inflows into India. Efforts in this direction would be very helpful in the post-capital account convertibility scenario. There exists tremendous potential for such a futures market in India, and it can give a boost to the Indian economy. Let us hope that a futures exchange for foreign currencies will be in place within the next two-three years.

FOREIGN CURRENCY OPTIONS

The presence of an active and liquid forex derivatives market is required to enhance the spectrum of hedging products available to residents and non-residents in order to hedge currency exposures. To ensure this, the RBI took the initiative and introduced foreign currency rupee options on 7^th July 2003. The aim was to neutralize currency risk on the country's large external debt portfolio and to provide banks and corporates with an effective hedging tool against currency risk. The market witnessed volumes to the tune of $250 million on 7^th July 2003, the very day it was introduced, showing the necessity of such an instrument in the foreign currency derivatives market. Foreign currency options allow one to purchase or sell a particular currency at a price denominated in another currency for a premium. The option premium varies from bank to bank depending on their out look on the currency. Only scheduled commercial banks, financial institutions and primary dealers are allowed to buy and sell rupee options.

The currency options provide the hedger with an advantage which is not available under a forward contract. If a US exporter has taken a forward contract to sell pound at $1.6500 he will receive only $1.6500 irrespective of whether pound is at $1.6000 or $1.7000. It will be an advantage if the exporter can get $1.6500 when the rate is $1.6000 and $1.7000 when the rate is $1.7000. It is this advantage which is available to a hedger when he uses an option contract. Options are available on many assets such as foreign exchange (e.g. on $/£, $/¥), equities (e.g. stocks and stock indices), commodities (e.g. gold, oil, soyabeans etc.,) and futures (currency, interest rate, etc.). Options are traded both on OTC and on exchange.

The options on foreign exchange markets particularly find option useful as they have traditionally been very volatile. In all the option contracts there will be two parties:

i. The option seller or writer and

ii. The option buyer.

The buyer of the option always has a right and no obligation whereas a seller always has an obligation and no right. Thus, the buyer of an option controls the exercise of right of buying (or the right of selling) currencies at the price fixed in the option contract. The seller of an option is thus dependent on the buyer’s decision. The buyer has the potential for limited loss and unlimited gain; the seller has potential for unlimited loss and limited gain.

A currency option, facilitates the hedging of an exchange rate exposure at a cost known upfront. The option writer assumes the exchange rate risk. Currency options are of two types:

· Call option

· Put option.

Call Option: A call option is an option to buy a currency. Thus, the buyer of a currency call option has the right to buy (take delivery of) a currency on or before a specified date at a predetermined exchange rate. The writer of a currency call option has the obligation to sell (deliver) a currency on or before a specified date and at the predetermined exchange rate.

Put Option: The buyer of currency put option has the right to sell (deliver) a currency on or before a specified date and at a predetermined exchange rate. The writer of a currency put option has the obligation to buy (take delivery of) a currency on or before a specified date at the predetermined exchange rate.

Hedging with Currency Options

The increasing use of currency options stems mainly from the realization that they permit far greater flexibility in managing the risk of foreign exchange. The hedger has an opportunity to hedge the exchange risk by using a simple call or put option or by acquiring positions in multiple options so that the combination provides a unique pay-off profile. It is not possible to give an exhaustive list of such combinations. The selection of an appropriate alternative by the hedger depends on the risk profile and view about the future market prices of the underlying asset.

The examples presented in this section are meant to give an overview of the available risk protection for a hedger with long or short position in a currency.

Hedging for Exporter

An Indian company exported goods to the US and expects payment after three months. The amount is equal to US$ 10 million. The amount of rupees the exporter will be receiving will depend on the spot rate of exchange prevailing then. Here, the exporter is exposed to vagaries of currency rates which may result in reduction of profit in the transaction or even resulting in a loss. The exporter, therefore, wants to hedge his rupee inflows through options. The hedger can be obtained by selecting one of the following alternatives.

Alternative 1: Buy a put option on US dollar with a strike price of Rs.43 by paying a premium of Rs.0.50.

Alternative 2: Sell a call option on US dollar with a strike price of Rs.43 by paying a premium of Rs.0.60.

Alternative 1: Exporter bought a put option at a strike price of Rs.43.00 per dollar by paying a premium of Rs.0.50 per dollar. Maturity of the contract is 3 months from now. Table 4.1 provides the rupee inflow to the exporter depending on spot rate prevailing at the time of realization of the receivables.

Table 4.1

Exchange Rate (3 months hence) Rs./$	Option exercised Yes/No	Rs. Inflow	Outflow on account of premium	Net inflow
40.00	Yes	43.00	0.50	42.50
40.50	Yes	43.00	0.50	42.50
41.00	Yes	43.00	0.50	42.50
41.50	Yes	43.00	0.50	42.50
41.90	Yes	43.00	0.50	42.50
42.00	Yes	43.00	0.50	42.50
42.50	Yes	43.00	0.50	42.50
43.00	Indifferent	43.00	0.50	42.50
43.50	No	43.50	0.50	43.00
44.00	No	44.00	0.50	43.50
44.10	No	44.10	0.50	43.60
44.50	No	44.50	0.50	44.00
45.00	No	45.00	0.50	44.50
45.50	No	45.50	0.50	45.00

At a Rs.0.50 premium, the effective delivery price after three months would be 42.50 (i.e 43.00 – 0.50) or more. If the dollar appreciates relative to the rupee well beyond the 43.00 level, the exporter will be able to sell the dollar currency at a spot price and hence the option is allowed to expire. If the spot price is less than or equal to Rs.43 then the option is exercised. Thus, the exporter is able to benefit from two advantages that the option market offered over the forward market, namely an opportunity to profit from a rally in the currency market and protection against a drop in the currency.

Alternative 2: Exporter is having another choice to hedge the receivables by selling the call option at a strike price of Rs.43.00/$ by receiving premium of say Rs.0.60 per dollar, for the contract maturing 3 months from now. Table 4.2 provides the rupee inflows to the exporter depending on the spot prices prevailing at the time of realization of receivables.

Table 4.2

Exchange Rate (3 months hence) Rs./$	Option exercised Yes/No	Rs. Inflow	Inflow on account of premium	Net inflow
40.00	No	40.00	0.60	40.60
40.50	No	40.50	0.60	41.10
41.00	No	41.00	0.60	41.60
41.50	No	41.50	0.60	42.10
41.90	No	41.90	0.60	42.50
42.00	No	42.00	0.60	42.60
42.50	No	42.50	0.60	43.10
43.00	Indifferent	43.00	0.60	43.60
43.50	Yes	43.00	0.60	43.60
44.00	Yes	43.00	0.60	43.60
44.10	Yes	43.00	0.60	43.60
44.50	Yes	43.00	0.60	43.60
45.00	Yes	43.00	0.60	43.60
45.50	Yes	43.00	0.60	43.60

Considering the premium of Rs.0.60 per dollar receiving for selling a call option, the effective delivery price after three months would be 43.60 (i.e 43.00 + 0.60) or less. If the dollar appreciates relatively to the rupee well beyond the 43.00 level, the option buyer will exercise the call option, the exporter will be able to deliver the dollar, received from the exports to the buyer.

As we see from both the tables 4.1 and 4.2, we find that rupee inflow under alternative 1 is higher than the inflow under alternative 2 when the spot rate is less than Rs.41.90 and when the spot rate is more than Rs.44.10. Where as the inflow under alternative 2 is more than the inflow under alternative 1 when the spot rate lies between Rs.41.90 and Rs.44.10. So the selling call option is superior to the buying put if the expected spot price at the maturity lies within the range of strike price the sum of two premiums. Thus, the selection of long put or short call depends on the expectation of the hedger about the spot prices that are likely to prevail at the time of exercising option.

Hedging for Importer

An Indian company is importing goods from Gulf country after three months. The payment is expected to be made in dollars at the time of importing goods. The value of import is US$ 10 million. The amount of rupees the importer will be paying will depend on the spot rate of exchange prevailing then. Here the importer is exposed to vagaries of currency rates which may result in reduction of profit in the transaction or even resulting in a loss. The importer, therefore, wants to hedge his rupee outflows through currency options. The hedge can be obtained by selecting one of the two alternatives.

Alternative 1: Buy call option on US$ with a strike price of Rs.43 by paying premium of Rs.0.60 per dollar.

Alternative 2: Sell put option on US$ with a strike price of Rs.43 by receiving premium of Rs.0.50 per dollar.

Alternative 1: Indian company bought call option at a strike price of Rs.43.00 per dollar by paying a premium of Rs. 0.60 per dollar. Maturity of the contract is 3 months from now. Table 4.3 provides the rupee outflows to the importer depending on the spot price prevailing at the time of realization of payables.

Guest

Table 4.3

Exchange Rate (3 months hence) Rs./$	Option exercised Yes/No	Rs. Outflow	Outflow on account of premium	Net Outflow
40.00	No	40.00	0.60	40.60
40.50	No	40.50	0.60	41.10
41.00	No	41.00	0.60	41.60
41.50	No	41.50	0.60	42.10
41.90	No	41.90	0.60	42.50
42.00	No	42.00	0.60	42.60
42.50	No	42.50	0.60	43.10
43.00	Indifferent	43.00	0.60	43.60
43.50	Yes	43.00	0.60	43.60
44.00	Yes	43.00	0.60	43.60
44.10	Yes	43.00	0.60	43.60
44.50	Yes	43.00	0.60	43.60
45.00	Yes	43.00	0.60	43.60
45.50	Yes	43.00	0.60	43.60

Importer by paying a Rs.0.60 premium, the effective price after three months would be 43.60 (i.e. 43.00 + 0.60) or less. If the dollar depreciates relative to the rupee below the 43.00 level, the public limited company will be able to buy the dollar currency at a spot price and hence the option is allowed to expire. If the spot price is more than Rs.43.00 or equal then the option is exercised.

Alternative 2: The Indian company is having another alternative to hedge the dollar payables by selling the put option at a strike price of Rs.43.00 per dollar by receiving premium of say Rs.0.50 per dollar, for the contract maturing 3 months from now. Table 4.4 provides the rupee outflows to the importer depending on the spot price prevailing at the time of realization of payables.

Table 4.4

Exchange Rate (3 months hence) Rs./$	Option exercised Yes/No	Rs. Outflow	Inflow on account of premium	Net Outflow
40.00	Yes	43.00	0.50	42.50
40.50	Yes	43.00	0.50	42.50
41.00	Yes	43.00	0.50	42.50
41.50	Yes	43.00	0.50	42.50
41.90	Yes	43.00	0.50	42.50
42.00	Yes	43.00	0.50	42.50
42.50	Yes	43.00	0.50	42.50
43.00	Indifferent	43.00	0.50	42.50
43.50	No	43.50	0.50	43.00
44.00	No	44.00	0.50	43.50
44.10	No	44.10	0.50	43.60
44.50	No	44.50	0.50	44.00
45.00	No	45.00	0.50	44.50
45.50	No	45.50	0.50	45.00

Considering the premium of Rs.50 per dollar receiving for selling a call option, the effective delivery price after three months would be 43.50 (i.e. 43.00 + 0.50) or more. If the dollar depreciates relative to the rupee well below the 43.00 level, the option buyer will exercise the put option; the importer will be able to take delivery of the dollar which will be used for import payments.

As we see from both the tables 4.3 and 4.4, we find that rupee outflow under alternative 1 is less than the outflow under alternative 2 when the spot rate is less than Rs.41.90 and when the spot rate is more than Rs.44.10. Whereas the outflow under alternative 2 is less than the outflow under alternative 1 when the spot rate lies between Rs.41.90 and Rs.44.10. So the selling put option is superior to the buying call if the expected spot price at the maturity lies within range of strike price the sum of two premiums. Thus the selection of long call or short put depends on the expectation of the hedger about the spot prices that are likely to prevail at the time of exercising option.

RBI Guidelines for Currency Options

An authorised dealer (AD) can offer currency options on the fulfillment of the conditions laid down by the RBI. These include:

• The ADs, basically banks, must have a minimum CRAR of 9 percent.

• Continuous profitability for at least three years.

• Minimum net worth of Rs 200 crore.

• Net NPAs (non-performing assets) at reasonable levels, i.e., not more than 5 percent of net advances.

• Trading in plain vanilla OTC European options is permitted

· Currency options are limited to the currencies of G-7 countries.

• Customers can purchase call and put options, the writing of options is not permitted.

• ADs may quote the option premium in rupees or as a percentage of the rupee/foreign currency notional.

• Only one hedge transaction can be booked against a particular exposure or part thereof for a given period.

• Banks should mark to market the portfolio on a daily basis.

• All the conditions applicable for rolling over, booking and cancellation of forwards contracts would be applicable to options contracts also,

• ADs have to report to the RBI on a weekly basis.

• Options contracts can be settled on maturity either by the delivery on spot basis or by net cash settlement in rupees on spot basis specified in the contract.

Guest

Table 4.3

Exchange Rate (3 months hence) Rs./$	Option exercised Yes/No	Rs. Outflow	Outflow on account of premium	Net Outflow
40.00	No	40.00	0.60	40.60
40.50	No	40.50	0.60	41.10
41.00	No	41.00	0.60	41.60
41.50	No	41.50	0.60	42.10
41.90	No	41.90	0.60	42.50
42.00	No	42.00	0.60	42.60
42.50	No	42.50	0.60	43.10
43.00	Indifferent	43.00	0.60	43.60
43.50	Yes	43.00	0.60	43.60
44.00	Yes	43.00	0.60	43.60
44.10	Yes	43.00	0.60	43.60
44.50	Yes	43.00	0.60	43.60
45.00	Yes	43.00	0.60	43.60
45.50	Yes	43.00	0.60	43.60

Table 4.4

Exchange Rate (3 months hence) Rs./$	Option exercised Yes/No	Rs. Outflow	Inflow on account of premium	Net Outflow
40.00	Yes	43.00	0.50	42.50
40.50	Yes	43.00	0.50	42.50
41.00	Yes	43.00	0.50	42.50
41.50	Yes	43.00	0.50	42.50
41.90	Yes	43.00	0.50	42.50
42.00	Yes	43.00	0.50	42.50
42.50	Yes	43.00	0.50	42.50
43.00	Indifferent	43.00	0.50	42.50
43.50	No	43.50	0.50	43.00
44.00	No	44.00	0.50	43.50
44.10	No	44.10	0.50	43.60
44.50	No	44.50	0.50	44.00
45.00	No	45.00	0.50	44.50
45.50	No	45.50	0.50	45.00