1. Corporate Uses and Abuses of Currency Options Prof. Ian Giddy New York University

2. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 2 Forwards vs Futures vs Options l Good credit: Forward usually best l Sometimes, Money Market Hedge better  Perfect market: same (covered int. arb.)  Imperfect market: MMH may be better l Credit problem: Futures  But: limited and standardized  Requires margin and daily settlement l Uncertain future cash flows:  Liquid instrument (futures/forwards to assure flexibility  Options sometimes advisable

3. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 3 Option Payoff Diagrams l Buy call: right to purchase foreign currency l Buy put: right to sell foreign currency

4. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 4 Gain or Loss Value of DM Plus: Short the currency Put-Call Parity Net effect: Buy a put Buy a Call

5. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 5 Option Combinations l Four classic ways of combining an option with a futures to create the opposite option

6. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 6 Value of Call Option INTRINSIC VALUETIME VALUE EXPECTED VALUE OF PROFIT GIVEN EXERCISE STRIKE FORWARD SHADED AREA: Probability distribution of the log of the forward rate on the expiration date for values above the strike.

7. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 7 Using Currency Options Known cash flows + option hedge = naked option  Hedging a known position  Covered call writing  Hedging with “cheap options”  Hedging with “free options”  Hedging contingent risk  Options receive favorable accounting treatment

8. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 8 Using Currency Options: 1. Hedging a Known Position l Example: Buy a Swiss franc put to hedge a royalty payment to be received from Switzerland Gain or Loss Value of Swiss franc + 0 -

9. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 9 Using Currency Options: 1. Hedging a Known Position l Example: Buy a Swiss franc put to hedge a royalty payment to be received from Switzerland Gain or Loss Value of Swiss franc Buy a Put

10. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 10 Using Currency Options: 1. Hedging a Known Position l Example: Buy a Swiss franc put to hedge a royalty payment to be received from Switzerland Gain or Loss Value of Swiss franc Net effect: Like buying a call

11. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 11 Gain or Loss Value of Swiss franc Plus: Buy a put Combining Options Net effect: Like buying a call Long a currency

12. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 12 Gain or Loss Value of Swiss franc Plus: Buy a put Put-Call Parity Net effect: Short the currency Sell a Call

13. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 13 Don’t Kid Yourself Option combinations: Owe currency + buy call = Buy put Own currency + buy put = Buy call

14. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 14 Using Currency Options: 2. Covered Call Writing l ICI proposes... +=

15. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 15 Using Currency Options: 2. Covered Call Writing l ICI proposes... l...the market disposes +=

16. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 16 l Example: Buy an out-of-the-money put to hedge a Swiss franc receivable l Question: When should a firm buy ATM options? l Answer: When the firm’s view of volatility exceds that of the market Using Currency Options: 3. Hedging with “Cheap Options” +=

17. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 17 What Influences Option Prices? l Forward relative to strike l Time to expiration l Volatility l Interest rate Option Value Currency Value

18. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 18 Using Currency Options: 4. Hedging with “Free Options” l Currency collar or range forward l Eg Exposure is obligation to pay for Japanese imports in 60 days ++ =

19. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 19 Case Study: “Options Trip” Japanese exporters long US dollars

20. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 20 Case Study: “Options Trip” += $10 million

21. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 21 Case Study: “Options Trip” += += $10 million $30 million

22. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 22 Using Currency Options: 5. Hedging Contingent Risk l Example 1: T.I. bidding to supply chips to Saudi Arabia

23. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 23 Using Currency Options: 5. Hedging Contingent Risk l Example 1: T.I bidding to supply chips to Saudi Arabia l Example 2: ABB lobbying to win high- speed rail contract in Florida

24. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 24 Using Currency Options: 5. Hedging Contingent Risk l Example 1: T.I bidding to supply chips to Saudi Arabia l Example 2: ABB lobbying to win high- speed rail contract in Florida l Problem: Wrong contingency l Solution: Event-contingent options

25. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 25 6. Using Options to get Hedge Accounting Treatment l Pfizer, the US drug company, uses forwards to hedge short-term foreign- currency payables and receivables l Pfizer uses long-dated options, as far out as 2 years, to hedge anticipated sales. This gets expensive! l Reason: GAAP would treat forwards used to hedge future, uncertain, sales as speculative, to be marked-to-market.

26. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 26 When Should Companies use Options to Hedge? l Hedge natural exposure  Example: Reeves sells printing blankets with fixed local-currency prices in Europe l Hedge against extreme events that threaten the company’s business.  Example: GE could buy deep out-of-the- money options on yen.

27. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 27 When Use Options to Take a View? l View on direction l View on volatility

28. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 28 Why Use Currency Options? l Protect against downside risk l Earn income from covered option writing l Buy “cheap options” l Buy “free options” l Hedge event-contingent risk l View on both volatility and direction l Hedge against financial distress

29. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 29 Which Instrument?

30. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 30 UNDERSTANDING THE EXCHANGE RISK MANAGEMENT PROBLEM n Value of hedging n Goals n Nature of the business UNDERSTANDING THE EXCHANGE RISK MANAGEMENT PROBLEM n Value of hedging n Goals n Nature of the business MEASUREMENT OF EXPOSURE ACCOUNTING TRANSACTION ECONOMIC NATURE OF THE CASH FLOW EXPOSURE: n One-shot? n Linear? n Contingent on exchange rates? n Contingent on other events? NATURE OF THE CASH FLOW EXPOSURE: n One-shot? n Linear? n Contingent on exchange rates? n Contingent on other events? HEDGING METHODS OPERATIONAL FINANCIAL Linear n Forwards n Futures n Debt n Currency swaps Linear n Forwards n Futures n Debt n Currency swaps Exchange-rate contingent n Options n Debt with option features Exchange-rate contingent n Options n Debt with option features Contingent on other events n Event options n Probability-based hedging Contingent on other events n Event options n Probability-based hedging Examples: n Sourcing flexibility n Pricing strategy n Market diversification Examples: n Sourcing flexibility n Pricing strategy n Market diversification A Corporate Foreign Exchange Roadmap

31. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 31

32. Copyright ©1997 Ian H. Giddy Options03:26 PM Uses and Abuses 32 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org