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FINC3240 International Finance Chapter 5 Currency Options 1.

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1 FINC3240 International Finance Chapter 5 Currency Options 1

2 2 What is an option? A derivative security that gives the holder (buyer) the right to buy or sell an underlying asset at a specified price (“exercise price”) on or before the option expiration date.

3 3 Two types of options: Call vs. Put options Call option Call option  Gives holder the right to buy an asset at a specified exercise price on or before a specified expiration date. Put option Put option  Gives holder the right to sell an asset at a specified exercise price on or before a specified expiration date.

4 4 Exercise price Exercise price Exercise price For a call option, it is the price set for buying the underlying asset.For a call option, it is the price set for buying the underlying asset. For a put option it is the price set for selling the underlying asset.For a put option it is the price set for selling the underlying asset. Exercise price is also called the strike price. Exercise price is also called the strike price.

5 5 Option premium Options are financial assets. If you want an option, you have to buy it from an option seller (counterparty). Options are financial assets. If you want an option, you have to buy it from an option seller (counterparty). The purchase price or cost of an option is the option premium. The purchase price or cost of an option is the option premium. The option seller earns the option premium. The option seller earns the option premium. The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the holder (buyer) ever exercises the option. The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the holder (buyer) ever exercises the option.

6 Examples At March 1, XYZ stock’s spot price = $95. A trader buys a call option on XYZ at strike (exercise) price = $100/share. The right lasts until August 15, and the price (option premium) of this call option is $2.5/share. At March 1, XYZ stock’s spot price = $95. A trader buys a call option on XYZ at strike (exercise) price = $100/share. The right lasts until August 15, and the price (option premium) of this call option is $2.5/share. At March 1, ABC stock’s spot price = $100. A trader buys a put option to on ABC at strike (exercise) price = $105/share. The right lasts until August 15, and the price (option premium) of this put option is $8.2/share. At March 1, ABC stock’s spot price = $100. A trader buys a put option to on ABC at strike (exercise) price = $105/share. The right lasts until August 15, and the price (option premium) of this put option is $8.2/share. 6

7 7 The long and short If you buy an option, then you are If you buy an option, then you are “long the option” or “long option” or you have a “long position”.“long the option” or “long option” or you have a “long position”. If you sell an option, then you are If you sell an option, then you are “short the option” or “short option” or you have a “short position”.“short the option” or “short option” or you have a “short position”. Example: if you buy a call option, you are “long call”.

8 Options Features There are always two positions in each option contract: Long for the buyer vs. Short for the seller (1)Buying a Call → Long a Call (2)Selling a Call → Short a Call (3) Buying a Put → Long a Put (4) Selling a Put → Short a Put 8

9 Positions Buyer (Long)Seller (Short) Call - Right to buy the underlying (i.e. to exercise the option) - Pays the premium - Obligation to sell the underlying, if buyer exercises the option - Receives the premium Put - Right to sell the underlying (i.e. to exercise the option) - Pays the premium - Obligation to buy the underlying, if buyer exercises the option - Receives the premium 9

10 10 Options trading (1) Option contracts are traded in two types of markets: Option contracts are traded in two types of markets: 1. Over-the-counter (OTC) markets 2. Exchanges, such as: Chicago Board Options Exchange (CBOE)Chicago Board Options Exchange (CBOE) Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME) International Securities ExchangeInternational Securities Exchange  Option Clearing Corporation (OCC)

11 11 Options trading (2) OTC 1. Option contract can be customized to needs of trader. 2. Difficult to trade. Secondary market illiquid. Exchanges 1. Option contracts are standardized by maturity dates and exercise price. 2. Easy to trade. Secondary market is liquid.

12 12 Options on IBM June 7, 2004 Source: Wall Street Journal Online Edition, June 8, 2004.

13 13 Underlying asset Individual stocks Individual stocks Stock market indexes Stock market indexes S&P 100, S&P 500, DJIA, Nikkei 225, FTSE 100 etc.S&P 100, S&P 500, DJIA, Nikkei 225, FTSE 100 etc. Futures Futures Foreign currency Foreign currency Treasury bonds, Treasury notes Treasury bonds, Treasury notes And many others.

14 14 Option exercise (1) To “exercise a call option” means the buyer uses the option to buy the underlying asset at the exercise price. To “exercise a put option” means the buyer uses the option to sell the underlying asset at the exercise price.

15 15 Option exercise (2) Question: When do you exercise an option? Answer: Simple. Only when it’s optimal to do so. That is, when you are better off exercising the option. Question: What if exercising the option does not make me better off? Answer: Simple. Don’t exercise. After all, it’s just an option.

16 16 American vs. European options American option: Holder has the right to exercise the option on or before the expiration date. American option: Holder has the right to exercise the option on or before the expiration date. European option: Holder has the right to exercise the option only on the expiration date. European option: Holder has the right to exercise the option only on the expiration date.

17 17 Payoffs of a Call Option Long Call at $20 Short Call at $20

18 18 Profit/Loss of a Call Option Long Call at $20 Short Call at $20 Short Call at $20

19 19 Profit/Loss of Long and Short on Call Option

20 20 Payoffs of a Put Option Long Put at $20 Short Put at $20

21 21 Profit/Loss of a Put Option Long Put at $20 Short Put at $20

22 22 Profit/Loss of Long and Short on Put Option

23 23 Call Option’s Payoff/Profit at Expiration Payoff for a Long Call: Payoff for a Long Call: Profit for a Long Call: payoff – option premium Profit for a Long Call: payoff – option premium Payoff for a Short Call: Payoff for a Short Call: Profit for a Short Call: option premium + payoff Profit for a Short Call: option premium + payoff

24 24 Put Option’s Payoff/Profit at Expiration Payoff for a Long Put: Payoff for a Long Put: Profit for a Long Put: payoff – option premium Profit for a Long Put: payoff – option premium Payoff for a Short Put: Payoff for a Short Put: Profit for a Short Put: option premium + payoff Profit for a Short Put: option premium + payoff

25 25 Example A trader short a Call at X=20 with a premium of $5. At maturity, the stock price is 30. What is the profit/loss to this trader? A trader short a Call at X=20 with a premium of $5. At maturity, the stock price is 30. What is the profit/loss to this trader? Profit/Loss = 5 + [-(30-20)] = = -5 A trader long a Put at X=30 with a premium of $5. At maturity, the stock price is 15. What is the profit/loss to this trader? A trader long a Put at X=30 with a premium of $5. At maturity, the stock price is 15. What is the profit/loss to this trader? Profit/Loss = (30-15) - 5 = = 10

26 26 Call option: Payoff & Profit at expiration Consider a call option on a share of IBM stock with an exercise price of $80 per share. Suppose this call option expires on July 16, 2004 and today is the expiration date. The current call option premium is $5. Consider a call option on a share of IBM stock with an exercise price of $80 per share. Suppose this call option expires on July 16, 2004 and today is the expiration date. The current call option premium is $5. 1.Are you better off exercising the option? 2.What is the payoff from the option exercise? 3.What is the profit from the option exercise? 4.What is the breakeven point for this call option (that is, the stock price at which profit is zero)? Answer these questions if IBM’s stock price is (a) 95 (b) 76 (c) 81.

27 27 Payoff & profit diagram of call option holder at expiration

28 28 Payoff & profit diagram of call option writer at expiration

29 29 Call Review Which of the following statements about the value (i.e., payoff) of a call option at expiration is false? Which of the following statements about the value (i.e., payoff) of a call option at expiration is false? a.A short position in a call option will result in a loss if the stock price exceeds the exercise price. b.The value of a long position equals zero or the stock price minus the exercise price, whichever is higher. c.The value of a long position equals zero or the exercise price minus the stock price, whichever is higher. d.A short position in a call option has a zero value for all stock prices equal to or less than the exercise price.

30 30 Put option: Payoff & Profit at expiration (1) Consider a put option on a share of IBM stock with an exercise price of $80 per share. Suppose this put option expires on July 16, 2004 and today is the expiration date. The current put option premium is $3. Consider a put option on a share of IBM stock with an exercise price of $80 per share. Suppose this put option expires on July 16, 2004 and today is the expiration date. The current put option premium is $3. 1.Are you better off exercising the option? 2.What is the payoff from the option exercise? 3.What is the profit from the option exercise? 4.What is the breakeven point for this put option? Answer these questions if IBM’s stock price is (a) 73, (b) 78 and (c) 81.

31 31 Payoff & profit diagram of put option holder at expiration

32 32 Payoff & profit diagram of put option writer at expiration

33 33 Put Review Consider a put option written on ABC Inc.’s stock. The put option’s exercise price is $80. Which of the following statements about the value (payoff) of the put option at expiration is true? Consider a put option written on ABC Inc.’s stock. The put option’s exercise price is $80. Which of the following statements about the value (payoff) of the put option at expiration is true? a.The value of the short position in the put is $4 if the stock price is $76. b.The value of the long position in the put is -$4 if the stock price is $76. c.The long put has value when the stock price is below the $80 exercise price. d.The value of the short position in the put is zero for stock prices equaling or exceeding $76.

34 Practice Questions To be assigned on the course website 34

35 35 Moneyness (1) An option (call or put) is: 1.In the money (ITM) if exercising it produces a positive payoff to the holder 2.At the money (ATM) if the asset price and exercise price are equal. 3.Out of the money (OTM) if exercising it produces a negative payoff to the holder.

36 36 Moneyness (2) S T < XS T = XS T > X Call optionsOut of the money At the moneyIn the money Put optionsIn the money At the moneyOut of the money

37 37 Moneyness questions (1) Consider two call options written on ABC Inc.’s stock. The first call, C1, has an exercise price of $50. The second call, C2, has an exercise price of $70. Both calls have the same expiration date. Today is the expiration date. C1 is in the money while C2 is out of the money. Which of the following is true about S T, the stock price on the expiration date? Consider two call options written on ABC Inc.’s stock. The first call, C1, has an exercise price of $50. The second call, C2, has an exercise price of $70. Both calls have the same expiration date. Today is the expiration date. C1 is in the money while C2 is out of the money. Which of the following is true about S T, the stock price on the expiration date? a.S T > $50 b.S T > $70 c.$70 > S T > $50 d.S T < $50

38 38 Moneyness questions (2) Consider two put options written on XYZ Inc.’s stock. The first put, P1, has an exercise price of $20. The second put, P2, has an exercise price of $35. Both puts have the same expiration date. Today is the expiration date. P1 is out of the money while P2 is in the money. Which of the following is true about S T, the stock price on the expiration date? Consider two put options written on XYZ Inc.’s stock. The first put, P1, has an exercise price of $20. The second put, P2, has an exercise price of $35. Both puts have the same expiration date. Today is the expiration date. P1 is out of the money while P2 is in the money. Which of the following is true about S T, the stock price on the expiration date? a.S T < $20 b.S T < $35 c.$20 < S T < $35 d.S T > $35

39 How to close a position? 1. reverse trading before expiration 1. reverse trading before expiration 2. execute the option 2. execute the option 3. wait for expiration 3. wait for expiration 39

40 40 Protective Put Strategy Portfolio consisting of a put option and the underlying asset. Portfolio consisting of a put option and the underlying asset. Guarantees that minimum portfolio value (payoff) is equal to the put’s exercise price. Guarantees that minimum portfolio value (payoff) is equal to the put’s exercise price.

41 41 Protective put: Payoff & profit at expiration S 0 = initial asset price, and P = put option premium. Cost of the position = asset price + put premium = S 0 + P = S 0 + P S T ≤ XS T > X Payoff of stockSTST STST Payoff of putX – S T 0 Total payoffXSTST ProfitX – (S 0 +P)S T – (S 0 + P)

42 42 Payoff & profit of protective put position at expiration

43 43 Currency Options A contract that is associated with a right to buy or sell a currency until after a specific date with a predetermined price (strike price) and amount. There are Call options and Put options. 1. The buyer of a Call option has the right, not the obligation, to buy a currency. 2. The buyer of a Put option has the right, not the obligation, to sell a currency. 43

44 Contingency (payoff) Graphs for Currency Options 1. Contingency Graph for a Buyer of a Call Option 2. Contingency Graph for a Seller of a Call Option 3. Contingency Graph for a Buyer of a Put Option 4. Contingency Graph for a Seller of a Put Option 44

45 Insert exhibit 5.6 page 123 Contingency Graphs for Currency Options 45

46 Currency Call Options Premium Factors Affecting Currency Call Option Premiums Factors Affecting Currency Call Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency 46

47 Currency Put Options Premium Factors Affecting Currency Put Option Premiums Factors Affecting Currency Put Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency 47

48 Call Options Application Hedge payables (Example on page 135) Hedge payables (Example on page 135) Pike Co. orders Australian goods and makes a payment in Australian dollars (A$) upon delivery. This company can buy an A$ call option that locks in a maximum rate. If at the maturity date the A$’s value remains below the strike price, Pike can purchase A$ at the prevailing spot rate and simply let its call option expire. If the A$’s value rises above the strike price, Pike will execute the option and buy A$ at the strike price. 48

49 Call Options Application A payment in A$1,000,000 will be delivered (paid out) at the end of June. A payment in A$1,000,000 will be delivered (paid out) at the end of June. On March 1, an option on A$100,000 that expires on June 28 has a strike price of $ On March 1, an option on A$100,000 that expires on June 28 has a strike price of $ Pike Co. buys 10 A$ Call options on March 1 and pay premium of $ Pike Co. buys 10 A$ Call options on March 1 and pay premium of $ On June 28, If the spot rate is $0.9050, Pike purchases A$ at the prevailing spot rate, and simply let its call options expire. If the spot rate is $0.9050, Pike purchases A$ at the prevailing spot rate, and simply let its call options expire. If the spot rate is A$1.050, Pike executes the options and buy A$ at the strike price, $ If the spot rate is A$1.050, Pike executes the options and buy A$ at the strike price, $

50 Put Options Application Hedge receivables ABC Co. will receive payment in C$2,000,000 at the end of September. ABC Co. will receive payment in C$2,000,000 at the end of September. On March 1, an option on C$10,000 that expires on September 28 has a strike price of $ On March 1, an option on C$10,000 that expires on September 28 has a strike price of $ ABC Co. buy 200 C$ Put options on March 1 and pay $ premium. ABC Co. buy 200 C$ Put options on March 1 and pay $ premium. On September 28, If the spot rate is $0.9400, ABC executes the options and sell C$ at the strike price, $ If the spot rate is $0.9400, ABC executes the options and sell C$ at the strike price, $ If the spot rate is $0.9600/$, ABC sells C$ at the prevailing spot rate, $0.9600, and simply let its put options expire. If the spot rate is $0.9600/$, ABC sells C$ at the prevailing spot rate, $0.9600, and simply let its put options expire.http://www.nasdaq.com/includes/canadian-dollar-specifications.stm 50

51 Speculation with Call Options (1) example on page 137, Mr. Jim Strike price=$1.4000/BP Strike price=$1.4000/BP Settlement date=December, 31 Settlement date=December, 31 Contract amount=31,250 BP Contract amount=31,250 BP No brokerage fees. No brokerage fees. Jim buys one Call option on June, 1 with premium of $0.0120/BP Jim buys one Call option on June, 1 with premium of $0.0120/BP Just before expiration, spot rate=$1.4100/BP. Just before expiration, spot rate=$1.4100/BP. Q1: Will the investor exercise the Call option? Yes. He exercises the Call option and then sell pounds with spot rate of $1.4100/BP. Q2: What is his profit/loss? ( )/BP more details in the textbook 51

52 Speculation with Call Options (2) Q&A 19 Call option premium=$0.03/C$ Call option premium=$0.03/C$ Strike price=$0.75/C$ Strike price=$0.75/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date. Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date. 52

53 Speculation with Put Options (1) example on page 140 Strike price=$1.4000/BP Strike price=$1.4000/BP Settlement date=December, 31 Settlement date=December, 31 Contract amount=31,250 BP Contract amount=31,250 BP No brokerage fees. No brokerage fees. One investor buy one Put option on June, 1 with premium of $0.0400/BP. Spot rate on June,1 =$ One investor buy one Put option on June, 1 with premium of $0.0400/BP. Spot rate on June,1 =$ Just before expiration, spot rate=$1.3000/BP. Just before expiration, spot rate=$1.3000/BP. Q1: Will the investor exercise the Put option? Yes. He will buy pounds from spot market at $1.3000/BP and then execute the put option. Q2: What is his profit/loss? ( )/BP more details in the textbook 53

54 Speculation with Put Options (2) Q&A 20 Put option premium=$0.02/C$ Put option premium=$0.02/C$ Strike price=$0.86/C$ Strike price=$0.86/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date. Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date. 54

55 55 Problems An investor traded two options on euro. The first call option has an exercise price of $ The second put option has an exercise price of $ Both options have the same expiration date. Today is the expiration date. At what price will the investor receive positive payoff from his portfolio? An investor traded two options on euro. The first call option has an exercise price of $ The second put option has an exercise price of $ Both options have the same expiration date. Today is the expiration date. At what price will the investor receive positive payoff from his portfolio?

56 56 Protective put 1 S 0 = initial currency price P = put option premium Cost of the position = currency price + put premium = S 0 + P = S 0 + P S T ≤ XS T > X Payoff of currencySTST STST Payoff of putX – S T 0 Total payoffXSTST

57 Protective put 2 You currently manages 1 million euro cash. Today’s spot rate is $1.100/euro. You expect that in the coming year euro will depreciate against US $. You buy a 12-month euro put option with a strike of $1.000 and a premium of $0.0300/euro. After 3 months, the prevailing spot rate is $0.9500/euro. You currently manages 1 million euro cash. Today’s spot rate is $1.100/euro. You expect that in the coming year euro will depreciate against US $. You buy a 12-month euro put option with a strike of $1.000 and a premium of $0.0300/euro. After 3 months, the prevailing spot rate is $0.9500/euro. (1)How much is the payoff (value) of your portfolio? (2)If the prevailing spot rate is $0.8000/euro, how much is the payoff of your portfolio? (3) what about $1.3000? 57

58 Homework 6 Chapter 5 Q&A: 6,7,10,11,12,13,21,22. Chapter 5 Q&A: 6,7,10,11,12,13,21,22. 58


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