Example 20.

6 Macquarie put Warrant

$opsidei'an Australian dollar put warrant against the U.S. dollar issued by Macquarie
wiih.a maturity date of December tS,lZOtO, tfrat qa{eJ on
PanK'' the Ausrralian Srock
was charactefized by a strike price of $0.90/AUD and a multi-
"I.nTtt:In-lwarrantpayoff to the put warrant was,.-s.pecifjed as :. ;1 .
plier...b,f.ApDl0,,tlie , ,,

Strike price pot rate I

X Multiplier
Spot rate J
F-gr
:example,,slrppsse the spot exchange rate was $0.95/AIJD at maturity. Then, the
settlement value for one warrant would have been

,,
($O.eolAUD) - ($o.ss/AUD)! xAUDlo:$0.59 :

Notethat,aiis,true'witfr exchange-ffaded options,'dn ihuestorrCan close out t{s position at

any point
fV selling the'waqant back into the market. Since the actual spot exchange rate
at maludry:was $r.023 3 I Aw,the holder of the wanant at maqriry *.J""0
prv"n
"",

2o.4 THe use oF oprroNs rN Rrsr< MeTecEMENT

Now that you understand the basics of foreign currency options, we can examine how they
can be used to manage foreign exchange risk. The classic use of a foreign cuffency
option
contract as a hedging device arises in a bidding situation.

A Bidding Situation at Bagwell Construction

Suppose that Bagwell Construction, a U.S. company, wants to bid on the construction of a new
office building in Tokyo. The Japanese developer has instructed all interested parties to sub-
mit their yen-denominated bids by June 30. Because the bids are complex contracts involving
many more parameters than just the overall yen price of the contract, it will take the Japanese
developer a month to evaluate the bids, and the winner will not be announced until July 31.
Bagwell management has determined that it can do the construction in Tokyo for
$80,000,000, which will be paid out more or less evenly over the course of a year. If the firm
gets the contract, it will receive yen revenue from the Japanese developer in five equal instali-
ments. There will be an initial yen payment on July 3 1, followed by four quarterly installments.

The Transaction Risk

By bidding a fixed amount of 5ren to do this projecq Bagwell Construction incurs transaction
foreign exchange risk. If Bagwell gets the project and the yen weakens relative to the dollar, the
contractual yen revenue will purchase fewer dollars in the future. Notice that as soon as Bag-
well bids on the contract, it acquires a transaction exposure. If the firm does nothing to hedge
its contingent yen asset exposure during the time that the contracts are being evaluated and the
yen weakens relative to the dollar, Bagwell's entire dollar profit could be eliminated before it
even begins construction. If its strategy is to get the contract and then hedge, it could be too late.

The Prohlem with a Forward Hedge

Can Bagwell Construction hedge this risk with a forward contract? If Bagwell sells yen for-
ward, it acquires an uncontingent yen liability. No matter what happens in 30 days, Bagwell
 will have to sell a specific amount of yen to the bank. Everything will be fine if Bagwell gets
the contract. But what would happen if Bagwell sells yen forward and then fails to win the
construction contract?
If the company does not get the construction job, it will still have to buy yen to fulfill the
uncontingent commitment of the forward contract. If the yen strengthens such that the dollar
price of yen in the spot market is higher than the contractual forward price, Bagwell will lose
money because it will cost more dollars in the spot market to buy the yen to be delivered on the
forward contact than the amount of dollars that the company will receive from the bank. Hence,
if the yen strengthens versus the dollar, Bagwell will lose money, possibly a lot of money.

The Options Solution

Foreign exchange options provide a much better solution to Bagwell's problem of hedging in
June prior to the resolution of the contract because options provide the purchaser with a con-
tingent claim. How would an option contract work, and which option should be used?
Because Bagwell ultimately wants to sell the yen it will be paid if it gets the contract, the
company should hedge by buying a yen put against the dollar. The yen put gives the buyer
the right, but not the obligation, to sell yen for dollars at the strike price. Then, jf Bagwell
gets the contract and ihe yen has weakened relative to the dollar, the loss of value on the
construction contract is offset by a gain in the value of the yen put. The company can sell yen
from the construction contract at the exercise price, which is higher than the dollar price of
yen in the spot market.
If Bagwell does not win the contract, the value of the yen put is the maximum that the
firm can lose. But if at the maturity of the option, the yen has weakened relative to the dollar,
the right to sell yen at a high dollar price will be valuable. Bagwell will consequently be able
to recoup some of the premium that was initially paid for the option. Purchasing the option
thus provides insurance against transaction risk.

Using Options to Hedge Transaction Risk

We now turn to the use of options in managing transaction exchange risk. While forwards and
futures can be used, options allow the firm to hedge while retaining some of the upside potential
from favorable exchange rate changes. Our next example considers an exporting situation.

Example 2O.7 Exporting Pharmaceutical

Products from the United States to the
United Kingdom
On Friday, October 1,2010, Pfimerc, an exporter of pharmaceutical products from the
United States to the United Kingdom, knew it had an account receivable of f500,000
due on Friday, March 19,2011. The following data were available:
Spot rate (U.S. cents per British pound): 158.34
170-day forward rate (U.S. cenrs per British pound): 158.05
U.S. dollar 170-day interest rate:0.20Vo p.a.
British pound 170-day interest rute:0.40Vo p.a.
Option data for March contracts in glf.:

Strike Call Prices Put Prices

158 5.00 4.81
159 4.52 5.33
160 4.08 5.89

)0 Part V Foreign Currency Derivatives

158 # lf 4.BZg, f f.
 Exhibit 20.5 Hedging Pound Revenues

E
c
3 Unhedged
o 163
o-
()
o- Buy a Put
a
F
c 160
o
O
'o Forward
158.05
r I

o 157 I

o i

E I

154 I

1 53.1 8 I

- I
laz.az
151
154 157158 160 163
March U.S. Cents per Pound

Notes:The horizontal axis presents different possible future exchange rates. The vertical axis represents the
revenue in cents per pound from three different strategies. The horizontal line reflects the revenue implied
by a forward contract, which is not dependent on the future exchange rate. The upward-sloping 45-degree
line represents the unhedged strategy. The revenue equals the future exchange rate. The "hockey stick" line
represents the revenue from hedging the receivable by buying a pound put option.

This occurs when Pfimerc exercises its puts-that is, when the future spot rate is
less than or equal to I58d,lf.. The option hedge provides a floor on Pfimerc's rev-
enue while allowing it to participate in any strengthening of the pound relative to the
dollar.
Notice also that the net revenue from the option hedge is below the net revenue
from the forward hedge when the exchangerate in the future is below a certain ex-
change rate, denoted Sx in Exhibit 20.5. ff the future spot rate is greater than Sx, the
net revenue from the option hedge exceeds the revenue from the forward hedge. This
is an example of no-free-lunch economics. If the option hedge puts a floor on your net
revenue, but it allows you to participate in a possible strengthening of the pound, which
increases your net revenue, the floor must be below the forward rate. Otherwise, the
option strategy would strictly dominate the forward strategy.
We can determine the value of ^9* by equating the two net revenues. The net rev-
enue from the option hedge is S* - 4.8201f., and the revenue from the forward hedge
is 158.059/f. Therefore, we find that S* is
S* - 4.829 lf. : 158.05A lf.
Sx : t 6Z.87g,lt.

Because the current spot rate is 158.34Q 1f,, the pound must strengthen relative to the
dollar by 2.86%o-ahat is, to 162.87q1f-bpfore hedging with puts provides a higher
net revenue than the forward hedge.
So should Pfimerc use the option strategy or the forward hedge strategy? To de-
cide, the company must calculate the probability that the exchange rate in the future will
exceed S*(O lf,). We discuss how this question is answered later in the chapter.

692 Part V Foreisn Curre rlcy Der"ivative:;

 i*"Tp-le
the !O_.8 tmporting Watches to
United States from Svvitzerland
consider the iase of an importer who must pay
in the exporter,s currency. Here, the
importer will ys.e optlon, tn"
"utt "" "-p"a"ri. *Or"
' . 's-uppose'ltis:Th,1{sday, septemb"i 16, *d "o.r*rr-r'"
otrojgl,iffiort", of swiss watches
to the United srates,-has an accounr payabre
December 15. The following data areuuJUUt., "r
cnrzlblb"do;;;;;il;;#;rr,
Spot rate:71.4Zp/CHF
90-day forward rate:7l.l4gi CHF
U.S. dollar 90-day interest rute:3.75Vo p.a.
Swiss franc 90-day interest rate:5.33Vo p.a.
Oprion data for December contracts (pZ6ffel,

Strike Call Put

70 2.5s 1.42
72 1.55 2.40

To hedge this transaction ucing foreign cuffency

options, orlodge must first oetermine
the^lvqe of oprioq thatprovides a hedge. e""aos"
h, d.uy'' fhe ffa-nsaction risk is tbat the Swiss rrun.
brl"ag; *nrf;
ilt;;;;;r"r*
?0. *iii rt u"r"r.., tt jon*,
yhich.increases rhe cost of the cHF750,000. To hedge,
that gives it the right, but not the obrigation, to
oril;;l;;ffi; *.
"ngtt "n " ]0,,*
uuy S*is irun., in 90 days at a sffike
price_of.dollars per swiss franc. This ii u europ*is;t;;;;""
ca'option. ':'^'
' '' ' Letl's,wprk.#ith the December swiss
"'CFIF:,The'cosrpeirunit -rrgc 9au
option *ltt a strite pnc,e: oi lzg:1
of rhis contractis 1.SSO/Cffe,;o, $0.,0155/CHF: As the buyer
ofthecontra-cts:orlodgemustpaytoday_.t-^-^,,qvvvrvv

lf' at maturity in December, the dollar value of the

swiss franc is greater than or equal to
the strike price of $0.7200/cHF, orrodge will
ii, ro buy cHF750;0;
"".r.i..
atthat price,.Consequently; OrtoOg.', *ki*u*puyrrr"n,
ir'"p,i""
, ,, , ,

. @so,ooo x $0,7200lcHF : $s+o,ooo;iis(r+*e) ! So zzo;1"# '

At all exchange rates ress than $0.7200/cHF, orlodge will

ket, and its cost will be:, :
buy francs in the ,pot *a,
cHF750,000 x s(r+88) < $s+0,000, if s(r+88) < $o.zzo0lcHF
whether ollodge exercises its option or not, if it hedges
with call options, it must add
the December value of the september cosr of the
call"opti""r L,rc"J##;il;
vvwuruer-uur
'the -swiss francs:to get a totalf iost figure. Trri, opffi;il;r;;;:-
$J1,62s x [l + r($)] : $11,62s x (1.0094):
$11,734
where the interest facror is^(3.751100X90/360) :
0.0094. Hence, Orlodge,s
- --- -o- - maxi_
^-^'
mum December total cost if it hedges with call options
is '
: $54o,ooo + $11,734 : g551,734
In cents per swiss franc, the December cost of the calr option
is
(T.ssa/CriIF) x (1.00e 4) : t.s6a/ctrc
 Exhibit 20.6 Hedging Swiss Franc Costs

74

73.56
Ec
o
o-
(I)
o-
972
c
o
O
a.
=
.E
a
o
O
70

70 71.14 72
U.S. Cents per Swiss Franc

Notes: The horizontal axis presents different possible future exchange rates. The vertical axis represents the
costs in cents per Swiss franc from three different strategies. The horizontal line reflects the cost implied by
a forward contract, which is not dependent on the future exchange rate. Jhe upward-sloping 45-degree line
represents the unhedged strategy: The cost equals the future exchange rate. The inverted "hockey stick" line
represents the cost from hedging the payable by buying a call option.

Exhibit 20.6 has possible December values of the exchange rate in cents per
Swiss franc on the horizontal axis and the cost in cents per Swiss franc on the verti-
cal axis. The different lines now represent the cost of different strategies, depend-
ing on the realization of the future exchange rates. As before, the 45-degree line
represents the unhedged strategy. If Orlodge chooses not to hedge, it must buy its
Swiss francs with dollars in the future spot market. Its cost will increase one for one
with any strengthening of the Swiss franc versus the dollar, but its cost will also be
lower, one for one, with any weakening of the Swiss franc.Its risk of loss is there-
fore unlimited.
The horizontal line in Exhibit 20.6 represents hedging with a forward contract. If
Orlodge buys Swiss francs forward at $0.71 14 I Clfr , its December cost is

$0.7ll4|CHF x CHF750,006 : $533,550

On a cents-per-franc basis, Orlodge's cost will be 71.14(,ICHF no matter what spot
exchange rate is realized in the future.
The kinked line in Exhibit 20.6 represents the total cost of hedging with the 72
December Swiss franc call options. The maximum total cost is

72.00c, lcIlF + 1.56Q/CHF - 73.560 lCHr

94 Part V Foreign Currency Derivatives

 .',,.Thip cosl a$pes when orlodge exercises its cutt options-trrat is,
rate in December is greater than or equal to 72.00; --=- -t' when
'v u.^r the
L'v rur
future spot
ICI{
,' ' ',The opli'onhedge provides a ceiling ol ollodle's,costs,,while allowing it to par-
o.r the doili rerative tJ tu"l*irs franc,
lf:*':::1,^T"is{:qns
me company's costs' Notice also that the total cost
which can reduce
total cost from the forward hedge whenever
from the option h"og" i"ub"u.
rh".;;il;. ;.
rut" in the future is above,s*.
If the future spor rate is tess th"an ,s*, rhe toral cost froil * ;;;;01" ,* ,"., ,n""
', 'j|1cost jgom'ttre,folward hedge. This ir uootfr", pf oo-free_lunCh
If the call option hedge puts a ceiling on your totar""u-pfe
cost, u* ";;"#;'l
iturn*,,;;;ffi;;
T
u po:rtb]e strengthening of the oo'irarti" .* *J#;;*
costs, thl ceiri,ie t.
-u*
above the forward rate.
The value of i* equates the total costs of the two hedges.
The total cost from the
option hedge is [s* + r-s6|/cHF], and the
CFIF. Therefore, solving for i* gives "ort
rro*-tte"forward h;;i;
;1.;;;:j
I '.,.'.', -,-,1r1',t,'ill :7r.r4(/cHF - r.56g,/crao: un,itul73 ,lt','','u' ,'
'
sx

T:Iyt::juo" -urt weaken by 2.Sgvorelative to rhe doilar, from7r.42g/cHF to

CW
69 f8(' f the call optioa
,before contract provides a lower cost than ,lr" i;;J#;g".
,"
,. as:,orlodge considers different strategiisfor dealing #;;;;r,
t
including alternative option strategies or ire forwardn"ig",
the firm should"lln"r"o*,
calculate the probability that the future spot rate will "-Jil";
be iess than ,sx. we will discuss
this in the nexr section, which compares option ilg;;;;p*.r,"r";|il;;;;".""'
t

Hedging with Options as Buying lnsurance

In the two previous examples, option strategies hedge
transaction exchange risks. Here, we
consider how hedging with options is analogous to
iurchasing insuran.".-B"for. we do so,
we summarize mote generally how to hedg-e foreign
receivables and payables with
"uo"n"y
forward, futures, and option contracts. pxliult z0lz gives
ari overview of this discussion. It
also includes some speculative option strategies that
we will discuss later.

Hedging Foreign currency Risk with Forwards and options

F'xporters y-ho,nri.ce in foreign cunency generate
foreign currency revenues. Their appropri-
ate forward hedge is to sell the foreign cuffency receivable
forward. Their appropriate option

Exhibit 2.O.7 Hedg ing a nd specu lating strateg ies

Underlying Transaction
Foreign Currency Receivable Foreign Currency payable
Forward Hedge Sell forward (Go short)
(or futures hedge) Buy forward (Go long)
Option Hedge Buy a put
i Buy a call
Establishes a revenue floor Establishes a cost ceilins
of K-(1 +i)P of K+ (l + i)C
Option Speculation Sell a call Sell a put
Imposes a revenue ceiling Imposes a liability floor
of K+(1 +i)Cbut of K-(1 +i)Pbut
allows unlimited risk allows unlimited risk

Notes: K is the strike price, C is the call option premium, P is

the put option premium, and i is the appropriate
deannualized interest rate factor.
 hedge is to buy a foreign currency put. The put provides the right, but not the obligation, to
sell the foreign currency revenue at the strike price of domestic currency per foreign cur-
rency, which establishes a floor on net revenue equal to the strike price minus the future
value of the option premium.
If you buy a put option, you are not contractually committed to sell the export revenue
through that option. You retain the right to sell the foreign cuffency in the spot market if the
domestic currency value of the foreign cuffency exceeds the strike price. A strenghtening of
the foreign currency allows your net revenue to exceed the floor established by the put op-
_ tion, and if the foreign culrency strengthens sufficiently, lour net domestic currency revenue
from the option hedge can substantially exceed the revenue from the forward hedge. Never-
theless, because some money is paid up front, the net revenue from the option hedge remains
less than the revenue that would have been generated if the option contract had not been
purchased. Naturally, this can only be known ex post-that is, after the realization of future
uncertain exchange rates. But, of course, the strategy must be chosen first.
For importers with foreign cuffency costs, the appropriate forward hedge is to buy the
foreign currency forward. The appropriate option hedge is to buy a foreign currency call
option contract. This gives you the right, but not the obligation, to buy the foreign currency
at the stlike price, which places a ceiling on your total costs. The ceiling on your costs is the
strike price plus the future value of the option premium.
If you buy a call option, you retain the right to buy foreign currency in the spot market
if the domestic currency value of the foreign currency is less than the strike price, and if the
domestic currency strengthens, your cost falls below the ceiling. If the domestic currency
strengthens a lot, the cost from the option hedge can be substantially less than the cost from
the forward hedge. But your total cost can never be less than the cost that would have been
generated if the option conffact had not been purchased. Once again, this can only be known
ex post, and, unfortunately, you must choose your strategy first.

Options as lnsurance Contracts

How are the examples just discussed like insurance policies? Consider the purchase of fire
insurance for a home. A homeowner pays annual premiums for insurance that provides a
certain amount of coverage in the event of a fre. The quality of the coverage can be varied.
The more of the home's value that the homeowner wants to protect, the more costly is the
insurance. Expensive insurance completely replaces the home if it is destroyed by fire, and
less expensive policies pay some fraction of the loss.
Clearly, the homeowner puts a ceiling on his possible losses by purchasing fire insur-
ance. If there is a fire, the homeowner can repair the home, and the insurance company pays
some part of the bill. But, suppose the homeowner lives in the home for 10 years, and no fires
occur. Ex post, the homeowner will not have needed fire insurance, but he will have paid 10
years of insurance premiums. The homeowner will also have captured the appreciation in the
home's value. Nevertheless, the homeowner will not be as well off as he would have been
without purchasing the insurance. Of course, this does not mean that purchasing the insur-
ance was a bad idea. It just means that the homeowner did not need the insurance when he
lived in the home.
With foreign currency transaction exposures, purchasing the right type of option is like
purchasing an insurance policy. Take Example 20.7, in which Pfimerc has a British pound
receivable. A weakening of the pound is like a fire because it destroys part of the value of
Pfimerc's pound asset. By contracting in advance with an option, some of the value is re-
placed. That is, if Pfimerc purchases a put option, it places a floor on the dollar value of its
pound receivable, even ifthe pound depreciates. If, on the other hand, the pound strengthens,
that is like an appreciation of the value of the home without a fire. Pfimerc ignores the put
option and sells its pounds in the spot market. The put option was not needed just like the
insurance policy was not needed if there was no fire.

96 Part V Foreign Cun'ency Deri vati ves

 C-hanging the Quality of the lnsurance poticy
can we carry the fire insurance analogy further? If a
hom'eowner can purchase different qual-
ities of fire insurance at different prices, is there a range
of insurance quality when it comes
hedging foreign exchange risk? to
Let's first consider hedging a foreign currency receivable
with a put option. High-quality
insurance in this context means that the floor on
our domestic curency revenue is as high
possible' As we discussed, the floor is directly as
related to the strike price of the put option.
The higher the strike price of the option, the less the
foreign must depreciate before
we can exercise the option and cut our losses. Just as "u.,"n.y
insurance that coverslnore losses is
more expensive, put options with higher strike prices
are more expensive. We discuss valua_
tion issues in more detail in the nexr section.
similarly, high-quality insurance in the context of a foreign
currency liability means that
we would like to make the ceiling on our cost of
the foreig'n cuffency as low as possible.
This can be accomplished by buying call options with
lowel sffike prices. Again, there is a
trade-off because these options will be more expensive.
To fully understand this, let,s work
through a numeric example. y

Example POr.g :purchasing

v Better, but More
ExpensiVe,,l;lnsu't ance
' Exlmel: orrodge was importing
|, ?0 1tul9,I{op?an swiss warches, and we worked with a
i::"::.":jl]:'.
r ne cost ro hedge the swiss franc "uJl
gqlio" wrttr a st4reiprice of 72g per swiss
liabililr ,was:1.s 5a lcHF. Alternatlvely, w" ill;
f;".
. gfrgose a Decdmber call option with a srrike price ;i;o;-l!;s-rhat cosrs 2.55A
-*: expensive "insurance" should provide u ror". l;#.
Il*
rranc cost' The trade-off is that the exchange rate, ""iling
on the toral Sffi;
si, at which O"rtooge nu, tn" ,urn"
cpst as the forward hedge is now lower. Hic";:trr" p_iou
il
thal the {oryzardheitge is srnaller because Orr"a!; gatr-Jto*"..,"ost ";;;"i;Tio'*lr""or,
only if the.future
exchange rate is less than this new
' Exliuit zo:bpr"g,,g, rrt* ."rioiagrams
,prices,
^S*.
for the twq opti;n:s*ategies witr,,t rt.
of.70 /Ct# ana 7ZA
g
/Ct*. The initiat "ort of tt i;;;ffi; ;;ii*d;
with the lower,stfikeoriCe is "

::Tp*d.to 11e
$11i6'25 in Exampl e 2.0.8.At mtSa in December, if the doltar value
ot the Swiss tranc is greater than or equal to the strike price
of $0.70/CHF, Orlodge
,yitt
lxg,rlise ffi6-*
lis oritiol to buy cuezsqooo ut,tr,at
thatoilodge.willpaji.in':becemberis1.l;....... ;;djl;Ir,J;;r-;_

At all exchange rates less than $0.70/CHF, Orlodge will

market, and itsrcost will be -- buy
--J Swiss francs in the spot

CrrzS0,000lx S(r+AS) .- $525,000, if S(r+88) .i$O.zO/CUp

Of course, Orlodge must add the December value of the cost
of the call options that
was paid in septemher to rhe December cost of trr" swis
ure. This opporfunity cost is
i;;t" ;;;;;;;rg_

[$ 19,125 x 1.oog4] =- $ 19,305

 r.,..:..:r.,r:,.;t:r-r:.;-..,..t,'. .',i.,':i, .1,'-.i.,' lr,:..:',t'r.,: .

..' ..,.. I t : :.':: :. t' .: .: :,.

fiteinative'Option Hedges
.

''()
73.56
(.d

,:lL. .', -r,'.. rtttt.':'

lb ,:r . .t, :i,.

.,

.Q- 7t:E7
..',..fi :, .,1

:if.z
,,O
,o t .: :,: ::

.;.,.'] ..'

t(f)
'3
.,9
ri
'"
a
o 70
'(J

68
S* =68.s7 71.14 Tz

Notes: The horizontal axis represents the future exchange rate in cents fer Swiss franc. The vertical axis
represeflts the cost in cents per Swiss franc of various strategies for dealing with a Swiss franc liability. The
horizontal line shows that a forward hedge locks in a cost per Swiss franc of 7 l.l4 cents. The 45-degree line
represents the unhedged stratg^gy,r and inverted 'hockey stick;t lirr"s represent the ex posr cosis of two qJ*l
option strategies, struck at different strike prices.

where the interest'factor is (l,ZS/tOO)(90/360) 0,0094.'Hence, the maximum to- ,:

tal cost that orlodge will puy io d""r-b", ir Ir n'"og"r ;irrt .rri
"pri;r;;---------'
'

In:Example 20:8; the conegfoiraing figure is'$551,73'4-H'*ibe,'prlodgbihaijrnproveO

the quality of its insur'anC6'be,Cause,itsltotal'cost is nowlower in the,bd'states,6f ,the
world in which the dollar weakens relative to the Swiss franc.
. . ', On ar cents:pei-franc,basis.'the Decernber cost of the call .bpffi with a's1q$e1 price

Hence,,the total costiof,tne fiabifity per unit of foreign ,currency iq, at most, ,
'l',,

W" agaiadete tne vafoe of ,5* that equates,the cost of the gption treOg" toith"
"an
cos_t the fgrward,hgdge.;The tEtS{ cost from the opriol hqdge,is s* +C.Slg|cuy,
9{
andthecbstfrom,th-eforwardhedgeis7I.L4SICHF.SolvingforSxgives','i,,r,,.,i",
".,,,i
!.: :i

s*= 7L,lfiolCHf. - 2.57QlCt.Jf' = 69.57f, fCHF

This is less than the Sx of 69.58 0 ICHF in Example 20.8. With more expensive insurance,
, nro;e,strengthgning of tlp do,llar rel{y9 to the Swiss franc must occur before Orlodgelsrcost
is lower than the iost of the forward hedge. Because the cirrent spot rate is'71.42A I CI.,
the Swiss franc must weaken by 3.99Vo,to 68.57QlCHF, before the call option conffact
. with a strike piice of 709/CHF provides a lower total cost than the forward hedge. l

Part V Foreign Currency Derivatives

 Speculating with Options
Examples 20'7 and20'8 discuss hedging transaction
exchange risk with options. choosing
the right strategy in these examples i; tantamount
to purchasing insurance. Sometimes, firms
think that this insurance is too expensive. If it is,
a f#m can profit from a speculative
as long as the tealized future exchange rate remains strategy
in ceriain regions. That is, rather than
purchase insurance, you can use the option
markets to sell insurance.
Ifpurchasing a put provides insurance when you have
a foreign currency receivable,
then selling a call allows you to sell the foreign
either to the purchaser of the
call option or in the spot market, and your revenue "urr"nly,
is enhanced by the option premium.
of course, you are now selling insurance to someone who may want to exercise the
option.
Similarly, if purchasin g a call seems too expensive when
hedging a foreign currency li-
ability, you might want to write a put. The put obligates you
to buy the foreign currency at
the strike price when the buyer of the put exercise,
tt ut opiion to sell foreign cuffency to you.
once again, though, the option premium provides you
with revenue that lowers the effective
cost of your foreign,currency liability. r
while we illustrate these strategies, you should understand
that speculating does not pro-
tect the firm's revenue from potential losses or its cost
from potential increases due to ex-
change rate changes. some of the large foreign
exchange losses experienced by firms in the
recent financial crisis arose because they were following
complex versions of these specula-
tive strategies, either through ignorance of the possiblJ losses
or an assessment that the ex
ante was worth taking.we come back to this issue.in section
'isk 20.5.

Speculating on Foreign Currency Beceivables

kt's illustrate these speculative strategies with the foreign curency receivable
inExanple20.7.
Suppose Pfimerq is scheduled to receive f500,000
in fiodays. The pound puroption provides
the hedge: It gives Pfimerc the right, but not the
obligation, to sell pounds at a contractual
strike price of dollars-per pound. But suppose this put
option seems expensive. would a differ-
ent option strategy allow Pfimerc to sell pounds for
doilars and have the potential to generate
more dollar revenue?
Pfimerc could achieve this objective by selling someone
the right, but not the obliga-
tion, to buy pounds,from it in exchange foidotlarrlrni,
option describes a pound call op-
tion against the dollar. Because Pfimerc knows the date on
which it wants io sell pounds
and the amount of pounds it wants to sell, it could sell
someone a European pound call
option against the dollar with 170 days until maturity. when pfimerc
sells the pound call
option, it generates dollar revenue in septei'nber, and ihi,
.ru.noe enhances its dollar return
in the future.
This strategy is speculative, though, because Pfimerc loses
protection against downside
risk' If the pound weakens substantially relative to the dollar,
the purchas., of th. pound call
option from Pfimerc will find it to be worthless. Pfimerc
will be iorced to sell its'pounds in
the spot market precisely when the dollar value of those pounds
is low. Also, its ability to
participate in a strengthening of the pound versus the
dor; is hmited.
Suppose that a[maturity the dollar-pound spot rate is
above the exercise price of the call
option contract. The purchaser of Pfimerc's call option will
consequently want to buy pounds
at the exercise price. Pfimerc will therefore have io sell
the pounds at the exercise price. The
company will then miss participating in any further strengthening
of the pound relatve to the
dollar' Nevertheless, Pfimerc does take in revenue for selling the
call options, and if options
are expensive, this revenue can be substantial.
 Example 2Q. 10 $peculating on Bnitish Pound
Receivables
To see how speculating on receivables works with actual data, let's examine the op-
tions on British pounds we used before. The March British pound call option with a
strikeprice of 158Alf, costs 5.009 f f.,or $0.05/f. If Pfimerc sells the call option in
October, it generates revenue of

f500,000 x $0.05/f : $25,000

In March, if the dollar value of the pound is above the strike price of $1.58/f, Pfimerc
will have to sell9500,000 to the option buyer, who will exercise the option to buy pounds
at the strike price. Pfimerc's maximum revenue in March will therefore be

f500,000 x $1.58/f : $790,000, if S (t+32) > $1.58/f

At all exchange rates less than or equal to $1.58/f, the option Pfimerc sold will be
worthless, so Pfimerc will sell its pounds in the spot market instead. Its revenue in
March will then be'

9500,000 x S(r+32) < if (t+32)

$790,000, S
= $1.5S/f
In both cases, though, Pfimerc can add the March value of the October revenue from
the option sale to get net revenue. This additional revenue is

$25,000 x (1 + t($)): $25,000 x 1.00094 : $25,024

where the interest factor is (0.20/100)(L701360) : 0.00094. Hence, the maximum
net revenue that Pfimerc receives in March if it sells the call option is

$790,000 + $25,024: $815,024

On a cents-per-pound basis, the additional March revenue is

5.09 1t x 1.00094 : 5.01(,1f.

This is the amount of extra revenue on a cents-per-pound basis that Pfimerc can use to
offset any weakening of the pound. To find the future spot exchan ge rate, S*(O I {), at
which Pfimerc has the same revenue as the forward rite, we equate the revenue from
the two strategies:

S*(olf) + s.}Lq,lf.: t58.050|f.

S*(alf) : t53.04Olf
Because the current spot exchange rate is 158.3491f, the pound would have to weaken
by 3.357o over the next 170 days before this strategy generated lower revenue than the
forward hedge. Exhibit 20.9 illustrates the revenue payoff for this speculative sffategy.
Notice that there is a range of values of future spot rates over which this spec-
ulative strategy has the highest net revenue. On a cents-per-pound basis, maximum
revenue from selling the option equals the strike price of I5SAlf.plus the 5.01A1f..
Consequently, the spot exchange rate in the future must be

1s8o l{. + s.jro lf. : t63.0tt lf

before the unhedged strategy provides more revenve ex post than the speculative op-
tion strategy. This requires an appreciation of the pound of 2.95Vo over the course of
170 days. If you think that the volatility of the exchange rate is not very large, the
probability of it reaching this value may not be very large.

)0 Part V Foreign Currency Derivatives

 Exhibit ZO,S Speculating with pound Revenue

E
:f
,,3
o
.,o_
':1-
o
,.Q
Cn

c
,{)
(J

o
ic
o 155
o
E
t,'

,153

.1 .'"

151
155 157 ,,.r 159
March U.S. Cents per pound
Notes:The horizontal axis represents the future exchange,rate
in cents.per pound. The vertical axis represents
the reven'e in cents p"t pouod of various^strategies
for-selling u pouoo'u*Ii1r," norirontal line shows
that
a forward hedge locks in revenue of 158.05
""nL.
the inverted "hockey stick" line represents the
Th" +s-o"freJune;d;;;dffi;;;i,i"-"o l"u
ex post revenieil ;;h"r%y of selling
a strike price a call option with
of 158.

lqggulating on Foreign Currency Liabilities

Exhibit 20'7 summarizes how the speculative strategies
work. In the case of a foreign
currency liability, you must buy foreign currency. selling
someone a foreign currency put
option forces you to buy the foreign currency at the strikJprice
when the buyer of the option
finds it advantageous to sell foreign currency to you-that
is, when the exchange rate of
domestic currency per foreign currency is lower than
the strike price. If the exchange rate
ends up higher than the strike price, the option expires
worthless, and you must buy the for-
eign currency in the spot market, exactly when it is relatively
expensive. However, whatever
happens, writing the option yields revenue, and this
strategy *uy be advantageous when the
exchange rate is not anticipated to move very far from
its Ju,,"nt value.

Options Valuation
we saw that the buyer of an option pays a premium to the seller of the
option. How expensive
is this type of contract? The purpose of this section is to give
you an intuitive idea about how
options are valued. The actual foniral valuation of optioni
is discussed in the appendix to this
chapter because it is quite mathematically complex.a

The Intrinsic Vitue of an Option

Recall that the intrinsic value of an Americ.ln option is
the return, or revenue, generated from
the immediate exercise of the option. Intrinsic value is
another way of describing whether an

aAn Excel spreadsheet

that performs the calculations can be downloaded from professor
Business School web site.-values of foreign currency options
Hodrick,s columbia
are usually air"ur."o in terms of the Garman-
Kolhagen (see Garman and Kolhagen, 198-3) model, an extension
of the iamous Black-scholes (see.Black and
Scholes, 1973) model.