1CHAPTER - 10 Currency Options EXOTIC SPECIALS International Financial ManagementP G Apte
2SHOUT OPTIONSWith a Shout Option the buyer can lock in the profit to date while retaining the right to benefit from any further upside. When the option buyer thinks the market has reached a high (call) or low (put), they 'shout' and lock in that minimum level. If the market finishes higher (call) or lower (put) than the shout level, the holder benefits further. The option can be structured with any number of "shout " opportunities.EXAMPLEA private investor is bullish on USD/CHF, but also expects USD/CHF to be very volatile. They are therefore afraid to miss out on temporary highs when using a normal USD/CHF call. This problem can be solved by buying a Shout Call option on USD/CHF. Traditionally, there is only one "shout" opportunity. The investor therefore has the opportunity to lock in a minimum profit on the option if USD/CHF rises above the strike. (The option can be structured with multiple shouts but the cost may be prohibitive). Should USD/CHF close above the strike and below the "shout" level, the investor is assured of receiving the "shout" less the strike as profit. If the USD/CHF closes above the "shout" level, the investor will receive that additional profit also. The payout can therefore be summarised as the maximum of: (a) "shout" less strike, and (b) close less strike.
3A maximum option is a bundle of vanilla options with a variety of features—different strikes, different underliers, some may be puts, others calls, but they generally have the same expiration date. Only one of these may be exercised, and this is chosen in the holder's favor at expiration.A minimum option is a bundle of vanilla options—like a maximum option. Only one of the options can be exercised, and this is chosen in the issuer's favor at expiration.A better-of option is a bundle of long forwards. All mature on the option's expiration date but have different underliers. At expiration, only one settles, and this is chosen in the holder's favor.A worst-of option is a bundle of long forwards. All mature on the option's expiration date but have different underliers. At expiration, only one settles, and this is chosen in the issuer's favor.A two-asset correlation option is linked to two underliers. It pays off like a vanilla option on one underlier if the expiration value of the other underlier is in a specified range. The vanilla option can be either a put or a call.
4Together, maximum options and minimum options are referred to as min-max options. Better-of or Worst-of options are referred to collectively as Alternative OptionsAn alternative option can result in the holder having to make a payment to the issuer at expiration. Consider a better-of option on three-month USD/EUR and USD/JPY forwards, both with a USD 100MM notional. If both exchange rates move against the holder, he will have to make a payment to the issue to settle whichever forward has declined least in value.Worst-of options blur the distinction between option issuers and option holders. Certainly, someone would require a premium or other compensation for holding a worst-of option. Worst-of options arise with bond futures that grant the short party the right to deliver any of several qualifying bonds.
5BALLOON OPTIONS DESCRIPTION EXAMPLE A Balloon Option is an option that "Balloons" in size once a certain trigger is reached. It is most commonly used in FX markets but can also be used in interest rate, equity and commodity markets.EXAMPLEAn investor believes that the USD will strengthen against Yen in the coming months. It is currently trading at 100. The investor also sees 110 as strong resistance, but believes that it will be broken. Rather than buy a straight USD10million call at the money spot (100) for 6 months, the investor can purchase an at the money Balloon call with a trigger of 110 and a multiple of 2. This means that the investor owns a 100 call in USD10mm. However, if USD/YEN ever trades at or above 110, the notional of the bought 100 call will double to USD20million.
6PRICINGUsing the above example, the Balloon 100 call is merely a straight 100 call for USD10mm plus a 100 call in USD10mm that knocks in at 110. The Balloon option premium is therefore the addition of the two premiums and is therefore always more expensive than a straight call on the original notional but cheaper than a straight call on the ballooned notional. The amount of "ballooning" is determined by the client. Obviously the greater the ballooning the higher the premium. The further the trigger level is away from the at the money, the cheaper the premium. (see "Knock-In Options")TARGET MARKETBalloon options are an alternative that appeals to any client considering ordinary calls, but in particular to those who have technically based views.
7ADVANTAGESThe Notional of the option increases when the option is most in the moneyLoss is limited to premium like all bought optionsCheaper than ordinary options on the ballooned notional.DISADVANTAGESMore expensive than straight options (on original notional)PRODUCT SUITABILITYBought balloon options: Simple Aggressive Sold balloon options: Complex Aggressive
8LADDER OPTIONS DESCRIPTION EXAMPLE With a Ladder option, the strike is periodically reset when the underlying trades through specified trigger levels, at the same time locking in the profit between the old and the new strike. The trigger strikes appear as rungs on a ladder. Ladder options can be structured to reset the strike in either one or both directions. The Ladder option is also known as a Ratchet option and Lock-In option.EXAMPLEAn investment fund that is bullish on the USD wants to buy USD calls. If the fund buys a European call it can only exercise the option at the maturity date. If it buys an American call though, it will face the problem of when to exercise the option. The fund decides to buy a Ladder Option with a strike of 1.35 and a ladder with rungs starting at 1.35, going upwards in steps of 0.05 to a maximum of Now every time USD/CHF reaches a new rung, the strike will be reset to that rung and a 0.05 profit locked in. So if during the lifetime of the deal USD/CHF reaches its high at , the highest rung reached will be 1.45 and the strike will thus be set accordingly, while the profit of 0.10 (= ) will be locked in. At expiry the fund will receive the greater of (a)closing spot less original strike, and (b) highest rung reached less original strike. If in our example, the highest level was but the rate closes at 1.23, the fund will receive 0.10 only. If however the spot closes at 1.462, the fund will receive
9LADDER OPTIONS : PRICING A Ladder Option can be viewed as a series of Knock-In and Knock-Out call and put options each struck at a different ladder level. Our above example is made up by combining a 165 call and a series of bought and sold Knock-In Puts (see "FX Knock-In Options").TARGET MARKETLadder options are applicable for risk averse option buyers as profits are progressively locked in without losing the option position.ADVANTAGESLess risky than traditional options as profits locked in as underlying performsNo need to constantly watch the underlying market levelsDISADVANTAGESMore expensive than a normal option
10BOX TRADEDESCRIPTIONA Box Trade is zero cost strategy, in that there are two knockout Barriers. Because it is zero cost the actual levels of barriers in a box trade will depend on market conditions. The customer has three options1 Specify the lower barrier.2 Specify the upper barrier.3 Specify barriers equi-distant from spotThe trader will find the other barrier (or the distance from spot) that makes the strategy zero cost. The wider the range the better the trade because not only is there a smaller chance of hitting the barriers, but also the pay out is larger.At expiration the possibilities and pay outs are:1) Spot has never touched either barrier - the pay out is Range * Notional Amount in Base currency terms (Range is the distance between each barrier).2) Spot has touched one barrier only, but ends up inside the range - the pay out is always positive and the amount is ABS(Barrier - Spot )* Notional Amount in Base currency terms, where Barrier is the level of the untouched barrier
113) Spot has touched both barriers but ends up inside the range - the pay out is zero. 4) Spot has touched one barrier only and ends up outside the range - the pay out is negative and equalsABS(Barrier - Spot) * Notional Amount,where Barrier is the level of the untouched barrier.
12CLIQUET OPTIONS DESCRIPTION EXAMPLE A Cliquet Option settles periodically and resets the strike at the then spot leyel. It is therefore a series of at-the-money options, but where the total premium is determined in advance. A Cliquet can be thought of as a series of "pre-purchased" at-the-money options. The payout on each option can either be paid at the final maturity, or at the end of each reset period.EXAMPLEA three-month Cliquet Call on the USD with monthly resets is a series of three monthly at-the-money spot calls. The initial strike is set at say Rs If at the end of month one, the USD/INR closes at 45.00, the first call matures Rs.1.00 in-the-money and this amount is paid to the buyer. The call strike for month 2 is then reset at If at the end of month 2, USD/INR is , the call will expire worthless. The call strike for month 3 is then reset at The alternative strategy would be to buy a one-month at-the-money call and at the end of month one, buy another at-the-money one month call, and so on. The difference is that the cost of the Cliquet is known in advance, whereas the future cost of at-the-money calls is unknown. If volatility is LOWER than expected, the Cliquet will be more expensive than buying the calls annually, if volatility is HIGHER than expected, the Cliquet will be cheaper. A Cliquet option is therefore more attractive when volatility is expected to RISE.
13CLIQUET OPTIONS (CONTD.) The major advantage of the Cliquet, is that the probability of some payout is high. Over the 3 year period, the chance that the market will close lower for three consecutive years, is much lower than the probability that the market will close lower at the END of three years i.e. there is a high probability that even if the market closes lower after three years, that it will have closed higher in at least one of the three years.PRICINGA Cliguet is a series of at-the-money options. We can calculate the expected value of these options by generating the implied forward volatility curve (some methodology as generating implied forward interest rates. See "Implied Forwards"). The Cliquet premium is the present value of the premiums for the option series. A Cliquet call is always more expensive than a straight at-the-money call with the same final maturity.The number of reset periods is determined by the buyer in advance. More resets make the option more expensive.
14CLIQUET OPTIONS (CONTD.) TARGET MARKETThe Cliquet is suitable for investors with a medium term investment horizon. It is less risky than ordinary medium term options, as there is less specific risk i.e. the reset facility gives the buyer a "second" and "third" chance. This increases the chance of payout, but must be balanced with the higher premium cost. As a series of "pre-purchased" options, the Cliquet is attractive to passive investors as it requires no intermediate management. They have traditionally been attractive to retail and private investors when embedded in deposits and bonds (see "Structured Assets ") as they provide a low risk (capital guaranteed) exposure to equity and Bond markets. Sophisticated investors use Cliquets to take advantage of future assumptions about volatility.ADVANTAGESThere is a "second chance" as the strike is periodically resetIdeal medium term, passive investmentLocks in the future cost of volatilityDISADVANTAGESMore expensive than straight options with same final maturity
15The Range BinaryFinally, let us consider the range binary, a structure that pays out a lump-sum if spot stays within a specific range without trading at either level in exchange for the payment of a relatively small upfront premium. Let's say that we are looking at USD/CAD (i.e. the number of Canadian dollars per 1 unit of the US dollar). We believe that USD/CAD is stuck in a range between 1.50 and 1.55 for the next two months. How do we take advantage of this view? We could buy simultaneously a double barrier USD call/CAD put with a strike of 1.50 that knocks out at either 1.50 or 1.55 and a double barrier USD put/CAD call with a strike of 1.55 that knocks out at either 1.50 or If spot stays in the range without triggering either 1.50 or 1.55, we will make on the notional amount of the options. The options themselves are relatively cheap because they are so likely to be knocked out. The higher the implied volatility, the more likely they are to get knocked out, the cheaper these structures.
16COMPOUND OPTIONS DESCRIPTION A Compound Option is an option where the underlying is another option. This option has two elements:1) the upfront premium and 2) the strike premium which will have to be paid later if the compound right is exercised. The upfront premium gives the right to buy or sell a specific option at the strike premium.Exotic Compound Options come in a variety of forms, such as a compound option with barriers, where the compound option can knockout before the exercise time, or where it has to knockin.A compound option on a Barrier option - in other words the right but not the obligation to buy a barrier option for a fixed amount at some date in the future.An option on a portfolio of options - the right but not the obligation to buy one or more options for a price fixed not at a future date.
17COMPOUND OPTIONS (CONTD.) EXAMPLEA major contracting company is tendering for the contract to build two hotels in one month time. If they win this contract they would need financing for CHF 223.5mm for 3 years. The calculation used in the tender utilises today's interest rates. The company therefore has exposure to an interest rate rise over the next month. They could buy a 3yr interest rate cap starting in one month but this would prove to be very expensive if they lost the tender. The alternative is to buy a one month call option on a 3yr interest cap. If they win the tender, they can exercise the option and enter into the interest rate cap at the predetermined premium. If they lose the tender they can let the option lapse. The advantage is that the premium will be significantly lower.Compound Options can also be used to take speculative positions. If an investor is bullish on USD/CHF, they can buy a 6mth call option at say 1.60 for 4.00%. Alternatively, they could purchase a 2mth call on a 4mth USD/CHF 1.60 call at 2.50%. This will cost say 2.00% upfront. If after 2mths the USD/CHF is at 1.65, the compound call can be exercised and the investor can pay 2.50% for the 4mth 1.60 call. The total cost has been 4.50%. If the USD/CHF falls, the option can lapse and the total loss to the investor is only 2.00% instead of 4.00% if they had purchased the straight call.
18COMPOUND OPTIONS (CONTD.) PRICINGFirstly the price of the forward starting option will be determined, using the implied future rates and volatilities. This option value is then used as the underlying for the compound option. As with normal options, volatility of the underlying will be a key factor of the value. However, with compound options it is more significant as it has a double effect. If volatility rises, this raises the value of the option. With a compound option, an increase in volatility will also increase the value of the underlying asset (another option).TARGET MARKETThe Compound Option can be used when there is uncertainty about the need for hedging in a certain period. A typical example is the tender for a contract as described above. The structure can also be used to leverage a position; with very little upfront premium it is possible to take substantial positions.ADVANTAGESLarge leverageCheaper than straight options
19Average Rate Options :Description There are two types of Average Rate Options:Average Spot Rate OptionAverage Strike Rate OptionAverage Spot Rate Options You select price, expiry date and averaging dates. The averaging dates can be as frequent as required and need not to be at regular intervals. Similarly, the averaging amounts do not have to be equal. Funds are not exchanged until the final value date, at which time you receive the difference between the weighted average rate over the given period and the agreed strike price if the option is in the money.
20Average Strike Rate Option You only select the expiry date, averaging dates and amounts. On the expiry date the weighted average rate becomes the strike price of the option. If this average rate/strike price is in the money at maturity, you receive the difference between the average rate/strike price and the spot rate at that time.Typical UsesA company, with periodic payments or receivables wishing to gain trend protection against unfavourable currency movements (Average Spot Rate Option).A company with an invoiced cost for materials based on the average of spot exchange rates over a defined period (Average Spot Rate Option).A company required to translate profits at average exchange rates on balance dates (Average Strike Rate Option).
21Average Strike Rate Option Example Exposure You are an Australian subsidiary of a foreign company which must, at the end of each year, translate profits at an average exchange rate. The required averaging dates are the end of each month. In order to repatriate the profits in one year you will need to sell AUD. Current spot price is and the one year forward rate isMarket ViewYou are unsure of the future direction of the AUD. You want to protect yourself against an adverse currency movement but would like to benefit from any appreciation in the AUD.
22Possible Solution Outcome You purchase an AUD Put Average Strike Rate Option with averaging dates at the end of each month. This would cost 2.70% of the USD amountOutcome1. If the average rate at year end is above the spot rate at expiry you exercise the option and the bank will pay the difference between the average rate (the rate at which you have translated your profits) and the spot price (the rate at which you can deal in the market at that time).2. If the average rate is below the spot price at expiry the option is allowed to lapse as you have dealt at more advantageous average rates in the spot market.
23Average Spot Rate Option Example ExposureYou are an Australian company that exports USD 1 million worth of goods to the US each month. You want to protect your receivables over the next 12 months. The current spot price isMarket ViewYou are unsure of the future direction of the AUD. You want to protect yourself against adverse currency movements but would like to benefit from any appreciation in the AUD.
24Possible SolutionYou purchase an AUD call Average Spot Rate Option with a strike of and averaging dates at the end of each month. The agreed source for the average rate is the 11.00am daily exchange rate recorded by the Reserve Bank of Australia on Reuters page HSRA This option will cost 1.85% of the USD amount.During the period, on each averaging date, you simply sell the US dollars you receive in the spot market for Australian dollars. By dealing as close to 4 p.m. as possible you can ensure that the average rate you effectively deal at over the year is very close to the average rate used to settle the Average Spot Rate Option.
25OutcomeAt the end of the period you will have effectively dealt at the average rate for the period.1. If the average rate for the period is greater than you will exercise your option and your bank will pay you the difference between the average rate and the strike price. The amount you receive will effectively lower your actual dealing rates on average, to (provided the basis risk between the rate source for the averaging process and the rate you actually deal at each month is minimal).2. If the average rate is below you would allow the option to lapse. In this case you will have benefited from the more advantageous averaging rate over the period in your monthly dealings.
26Advantages Disadvantages Protection from adverse movements in exchange rates coupled with the flexibility to take advantage of favourable movements if they occur.Structures tailored to your requirements as to strike price, averaging dates, expiry date and amount to be averaged at each date.Cost effective relative to a standard option.Simplifies exposure management. Changes to payments need not cause changes to the option.DisadvantagesPremium Payable up-front.Net settlement occurs only at end and thereby not matching cash flows. Basis risk between settlement rate (a mid point) and actual dealing rate.
27FADE IN OPTION DESCRIPTION There are two varieties, regular fade in and reverse fade in. They are like the corresponding barrier options (Knockin and Reverse Knockin respectively) in that there is a single barrier level, but instead of the option appearing when it is hit, for each day that spot fixes past the barrier, some amount of the option notional is added.Why?Like knockins and reverse knockins they can cheapen options, but even more so. Note too the option can start partially knocked in.
28FADE OUT OPTION DESCRIPTION There are two varieties, regular fade out and reverse fade out. They are like the corresponding barrier options (Knockout and Reverse Knockout respectively) in that there is a single barrier level, but instead of the option disappearing when it is hit, for each day that spot fixes past the barrier, some amount of the option notional is reduced.WHO/WHENLike knockouts and reverse knockouts they can cheapen options but are less risky since they do not knockout completely. Note too the option can start partially knocked out.
29Forward Extra Forward Extra Strike: 109.0 Trigger: 96.45 Zero Cost AssumptionExposure Short EUR/JPYBudget Rate ATMFSpot Rate6Mth Fwd RateForward ExtraForward Extra Strike:109.0Trigger:96.45Zero Cost
30This structure allows the holder to take advantage of a guaranteed forward rate of , with an opportunity to benefit from a limited depreciation in the EUR against the JPY.If the EUR depreciates / JPY appreciates, but not beyond 96.46, the holder will be able to purchase EUR at the prevailing market rate at expiration.The best case rate at expiry would be (96.45 not traded prior to expiry), a 10.6% improvement on the forward rate available at inception.If the underlying trades at at any time during the life of the Forward Extra, the holder is obliged to purchase EUR / sell JPY at
31For an additional twist to the Forward Extra outlined above, a window can be added to the trigger. Therefore, unlike the Forward Extra where the trigger is live throughout the life of the structure, the trigger in the Window Forward Extra is only live within the window period. This period is defined as either a Front Window, occurring at the beginning of the contract or a Back Window, occurring towards maturity.Window Forward Extra Window Fwd Extra strike:Window Period: Back 2 MthsTrigger : Zero Cost
32This structure again allows the holder to take advantage of a guaranteed forward rate of , with an opportunity to benefit from a limited depreciation in the EUR against the JPY.If the EUR depreciates / JPY appreciates, the holder will be able to purchase EUR at the prevailing market rate at expiration as long as the underlying has not traded at in the window period.The underlying can trade at the trigger in the 4Mths prior to the window period without eradicating participation potential.The best case rate at expiry would be 98.61, an 8.6% improvement on the forward rate available at inception.If the underlying trades at during the window period, the holder is obliged to purchase EUR / sell JPY at
34This structure provides the holder with an opportunity to hedge at a rate that favorably exceeds the Forward contract alternative. In this example, the purchase of EUR / sale JPY at versus the ForwardThe holder will be hedged at all times and both the Boosted and Reset Rate are known to the holder at inception.If the pre-determined range remains unbroken by expiry, then the holder purchases EUR / sells JPY at a 4.1% improvement over the forward.If the underlying trades outside the range, the holder will purchase EUR / sell JPY at This is the worse case rate (1% out-of-the-money forward) and is known at inception.
35A Canadian Co. has to buy US$10m in 6 months time A Canadian Co. has to buy US$10m in 6 months time. It is in a highly competitive industry with tight margins. It has established a budget target of for these USD purchases. The current 6 month forward rate isFlexible ForwardsWith the flexible forward, the company could consider the following strategy which combines aspects of the Vanilla Option and the Forward.Example The company has the right to buy USD in 6 months at no worse than This option converts to a forward at in 6 months time if the spot hits No up-front premium.In essence, the company can avail of all USD weakness up to This potential would not exist with the standard forward. Of course, if the spot hits , a company is left with a forward
36Flexible Participating Forward Example The Canadian company has the right to buy USD in 6mths at no worse than the budget rate of (eg Vanilla Option)It can avail of all USD weakness up toIf however, the spot hits over the next 6 months, the option hedge turns into a Participating Forward with a 40% participation rate.Therefore, the company has guaranteed a worst case rate of , in line with the budget target. However, the company can avail of 40% of all favourable moves (ie USD weakness) at maturity. So for example, if the spot is at maturity A Co. effective USD purchase rate is approx and 40% at ).
37Options on FuturesA call (put) on a futures contract with strike X gives you the right to establish a long (short) position in the futures contract at a futures price X. If you exercise, your position will be marked to market at the end of the day.A September EUR futures contract on EUR is currently trading at $1.0660; if you exercise a call with strike , you become the owner of one September EUR futures contract with a price of $ You will open a margin account with a deposit of say 5% of the contract value. If the settlement price is $1.0660, your margin account will be credited with $( )(125000) = $8875.
38Futures Style OptionsFirst consider a forward contract expiring at time T on an option with the same expiry date. The option is on the underlying currency. Essentially you pay the option premium at the time of expiry. A futures style option is like a forward-style option but with marking-to-market.Suppose you buy a futures style option on EUR at a price of $0.02 per EUR. You pay a margin as in futures. On the second day the option settles at $0.03. You can withdraw $(125000)( ) = $1250. Next day the option settles at $0.035 and expires. You gain a further $625 and now have to pay $0.035 premium per EUR. Ignoring time value you pay a net amount = $( ) = $2500. Whether you exercise the option or not depends upon (ST – X).