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Foreign currency options: Reducing exchange risks: an innovative approach

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1985
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Robert A. Feldman

In recent years interest in ways of managing foreign currency exposure has increased considerably in light of large and, at times, erratic changes in exchange rates. Forward markets for foreign exchange have, of course, existed for some time for most major currencies, and the ways in which these markets can be used to reduce the risks from foreign currency exposure are well known. A more recent innovation, foreign currency options, adds a new dimension to the ways of protecting against (hedging) exchange rate risks.

Basically, a foreign currency option is a contract that provides its holder the right (but not the obligation) either to purchase or sell a predetermined amount of foreign currency at a specified exchange rate on or before the maturity date of the contract. Although their use is not yet widespread, foreign currency options appear to have a great deal of potential as reflected in the establishment of trading in these options on organized exchanges in the United States, Europe, and Canada, and in the rapid increase in trading volume. Some exchanges have recently increased the number of currencies in which options contracts are traded, while others have just started trading in foreign currency options for the first time. Foreign currency options may ultimately become an important financial instrument in facilitating international trade by reducing some of the risks associated with a flexible exchange rate system.

Along with highlighting the terminology, mechanics, and advantages associated with using foreign currency options to hedge foreign currency exposure, this article discusses market arrangements for buying and selling such options. Given space limitations, however, the discussion is brief and selective. For example, the relationship between options, forward, and spot markets for foreign exchange is not explicitly discussed, although this interaction can play an important role in the development of the options market.

Types

There are two basic types of foreign currency options: call options and put options. A call option is a contract that provides the contract holder with the right to purchase an agreed amount of foreign currency at a specified price (exchange rate) on or before the maturity date of the contract. A put option provides the contract holder with the right to sell an agreed amount of foreign currency at a specified price on or before the maturity date. The specified price at which the foreign currency can be bought or sold is called the exercise or striking price. An option that can be exercised at any time up to the maturity date of the contract is known as an American option, while an option that can be exercised only on the maturity date of the contract is known as a European option.

The buyer of an option contract pays to the seller of the contract a fee, called the premium. By paying the premium to the seller (also called the writer of the option contract), the buyer (also called the contract holder) purchases the right to exchange foreign currency with the seller of the contract at the striking price; the holder makes the decision of whether or not to exercise the option. The seller of an option contract has exchange rate risk transferred to him, and sells the contract because in his view the premium received is sufficient compensation for his potential loss. The premium is the price of the option contract which moves to equilibrate supply and demand. For example, if a given premium did not provide sufficient compensation for the risk that sellers bear, there would be fewer sellers than buyers at that premium, and the premium would be driven up.

Advantages

Foreign currency options have a number of advantages over forward or futures contracts as a means of averting exchange rate risk. One of the main attractions of foreign currency options is that they add more flexibility to risk management than is available with existing forward or futures foreign exchange markets. This flexibility stems from the fact that a foreign currency option literally entails an option and not an obligation. As a hedge, a foreign currency option limits the risk of an adverse change in the exchange rate by “locking in” the exchange rate given by the striking price. At the same time, the option gives its holder the ability to take advantage of any beneficial change in the exchange rate because the option need not be exercised. And no matter how the exchange rate moves, the holder of an option cannot lose more than the premium because there is not a binding obligation to exercise the option. By contrast, a forward or futures contract requires the holder of the contract to acquire (or provide) the underlying currency at the set exchange rate or close out the contract. Thus, forward or futures contracts entail a binding obligation, irrespective of subsequent changes in exchange rates or in the circumstances of the contract holder.

A further advantage of foreign currency options applies to situations—common in the normal course of international operations—where economic entities face exchange rate risks because of uncertainties about whether future foreign exchange transactions will take place. Foreign currency options are ideally suited to protect against such contingent risk exposure. For example, if a firm submits a bid to produce a particular item (say turbines) for export, but is uncertain about whether the bid will be accepted, the potential foreign currency receivable can be hedged with a put option: if the bid is not accepted, the option does not have to be exercised and the cost of hedging is limited to the premium; if the bid is accepted, however, the put option ensures that the firm can sell the foreign currency received at the striking price and is thus protected against the risk of an adverse movement in the exchange rate. Furthermore, the premium is known at the time the option is purchased, and use of an option therefore allows the firm to incorporate fairly complete and certain hedging costs into initial construction of the bid. If the firm had instead engaged in a forward contract to sell the potential foreign currency receipts and the bid was not accepted, the firm would have remained obligated to engage in a foreign currency transaction, a transaction that could have been risky. In such a situation the losses (or gains) from closing out the forward position could be large and, in any case, would be unknown until the time that the bid was rejected. In general, a foreign currency option is well suited to reducing exchange rate risk whenever there is uncertainty about a future foreign currency transaction.

An additional advantage of the so-called American foreign currency options is that they allow the holder to remain flexible with respect to the timing of anticipated foreign currency inflows or outflows, as the option can be exercised at any time up to the maturity date. A forward or futures contract, by contrast, binds the participants to undertake a foreign currency transaction on a given day and at the given exchange rate. The choice of a striking price can be a further attraction of foreign currency options; by comparison a forward or futures contract provides a choice of only whether or not to buy (or sell) at a given premium or discount on the spot exchange rate.

Market arrangements

Foreign currency options are now bought and sold either on an over-the-counter basis, analogous to forward exchange markets, or in organized trading on exchanges, analogous to futures markets. One of the advantages of over-the-counter options is that they can generally be “customized” to meet specific needs, such as hedging an odd-sized amount of foreign exchange exposure or hedging exposure in a currency for which standardized contracts are not traded on organized exchanges. The diversity in over-the-counter options contracts (just as with forward contracts) means, however, that they are not readily tradable and that canceling a deal requires agreement from the original contracting party. By comparison, standardized foreign currency option contracts (just as with futures contracts), such as those traded on organized exchanges, can be easily bought and sold, and costs in premiums can be reduced by accepting a standardized contract rather than a tailor-made one.

Over-the-counter options. Banks and finance houses in the United States and in Switzerland reportedly started writing customized foreign currency options for their customers before foreign currency options trading began on organized exchanges. The larger Swiss banks have also reportedly begun to trade over-the-counter options among themselves, offering quotes on contracts that are standardized by maturity date and contract size. London is another important source of over-the-counter foreign currency options. As in Switzerland, an interbank currency option market is developing, and in July 1984 a formalized trading system was inaugurated that reportedly allows banks to post prices anonymously on trading screens (such as Reuters and Telerate) in order to reach a larger market.

One problem from a bank’s standpoint is the uncertain foreign exchange exposure created by selling an option; a bank cannot know the size of its exposure until the holder either exercises the option or lets the option expire. A perfect hedge for selling an option is, however, buying an identical one. Banks have reportedly contributed to the development of exchange-traded options by using those options to hedge some of the foreign exchange exposure they take on writing options for their customers.

Organized markets. Trading in foreign currency options on organized exchanges is a relatively new development, having begun on the Philadelphia Stock Exchange in December 1982. Since then, trading in such options has also begun on the Chicago Mercantile Exchange, the European Options Exchange in Amsterdam, and the Montreal Exchange in Canada—all of which trade so-called American options exclusively. More recently, in May 1985, the London Stock Exchange also began trading American-style foreign currency options, as did the London International Financial Futures Exchange in June 1985, and in September 1985 the Chicago Board Options Exchange began trading so-called European options.

When the Philadelphia Exchange—which is the oldest and largest of the organized markets and therefore is given greater attention—started trading currency options in December 1982, only pound sterling option contracts were listed but the Japanese yen, the Swiss franc, the deutsche mark, and the Canadian dollar were added within three months, and in September 1984 a new option contract on French francs was added. The sizes of the option contracts are standardized at £12,500, DM 62,500, Sw F 62,500, ¥6,250,000, Can$50,000, and F 125,000, and the expiration dates are set at the second Saturday of March, June, September, and December. Foreign currency options on the Philadelphia Exchange open with terms to maturity of three, six, and nine months, and the striking price is stated in US dollars per unit of foreign currency; when a new option contract is listed for trading there are at least four put and four call striking prices around the prevailing spot exchange rate.

Trading volume was initially fairly low on the Philadelphia Exchange, but began to pick up markedly after the first year. The average volume of foreign currency options traded on the Philadelphia Exchange did not reach 1,000 contracts a day until September 1983, i.e., after the first nine months of trading, but the volume doubled in the next four months and exceeded 5,000 contracts a day in March and again in June of 1984. Trading volume has continued to grow markedly since then, peaking at over 19,000 contracts in February 1985 and averaging almost 15,000 contracts in September 1985.

European customers are reportedly a party to more than half the foreign currency options traded on the Philadelphia Exchange. Trading activity in foreign currency options on the European Options Exchange in Amsterdam, however, has been comparatively low, perhaps limited in the past by the small number of currencies for which contracts are available and the relatively small sizes of the contracts.

Trading activity in foreign currency options contracts on the Montreal Exchange had also been comparatively low and probably limited by the relatively small sizes of the contracts. Recently, however, both the Montreal and the European Options Exchanges have increased some contract sizes to amounts closer to those traded in Philadelphia, and at least one new contract on £100,000 payable in US dollars is substantially larger. The Montreal Exchange now trades options on most of the currencies available on the Philadelphia Exchange, exceptions being the Japanese yen and the French franc, while the European Exchange trades Netherlands guilder/US dollar, US dollar/deutsche mark, and US dollar/ pound sterling contracts; both exchanges have announced plans to add additional contracts.

Foreign currency call options: an example

Consider a hypothetical example of a US importer buying machinery from Germany. The importer knows the bill will come due in three months, when he must pay the German producer of the machinery DM 31 million, or $10 million, say, at a spot exchange rate of DM 3.10 per US dollar. To hedge against adverse movement in the exchange rate, the importer pays a $200,000 premium to buy a European call option that gives him the right to buy in three months DM 31 million at a striking price of DM 3.10 per US dollar. (For simplicity, it is assumed that the striking price and the spot exchange rate when the option is purchased are the same, and the option can only be exercised on the maturity date of the contract.) Three of the possible outcomes after three months are:

  • (1) The DM appreciates from DM 3.101$ to DM 3.001$. Without the option, the US importer would have to pay $10.3 million, that is the DM 31 million owed to the German producer converted into dollars at the new spot rate of DM 3.00/$. By exercising the option, the US importer instead pays $10 million for the DM 31 million. Hedging with the option cost $200,000 for the premium but saved $300,000. (Figures are rounded to the nearest $100,000. For simplicity the interest foregone on the $200,000 premium does not appear in the calculations.)

  • (2) The DM depreciates from DM 3.101$ to DM 3.201$. The US importer pays $9.7 million (DM 31 million converted into dollars at the new spot rate of DM 3.20/$), or $300,000 less than the amount calculated on the basis of the initial spot rate. The option is not exercised because doing so would mean paying $10 million rather than $9.7 million for the needed deutsche mark. Hedging with the option thus cost $200,000 for the premium, but because there was no obligation to exercise the option the importer was able to benefit from the $300,000 decline in the cost of the machinery as a result of the depreciation of the deutsche mark.

  • (3) The DM remains unchanged at DM 3.101$. The US importer is indifferent between exercising and not exercising the option, because in either case the machinery will cost him $10 million. There are neither gains nor losses on account of exchange rate movement, but there is a cost of $200,000 for the premium.

The decision to exercise the option depends on whether the foreign currency in question appreciates or depreciates relative to the striking price. If the deutsche mark appreciates in the above illustration, the call option would be exercised because the option allows its holder to buy the needed foreign currency at a more favorable exchange rate. The option would not be exercised if the deutsche mark depreciates because it would then be cheaper to buy the currency at the new spot rate than at the striking price. Unlike a forward or future contract, the option allows the importer to take advantage of the depreciating foreign currency by simply not exercising the option, although he incurs the “insurance” cost of the option’s premium. By using the foreign currency option to hedge, the importer cannot, however, lose more than the premium; options thus limit the downside risk from exchange rate movements while allowing the contract holder to profit from any favorable exchange rate changes.

Clearly the importer could have chosen not to cover his foreign currency exposure at all. Had he done so and had the deutsche mark depreciated or remained unchanged, he would have been better off—in an ex-post sense—since the option he might have purchased would not have been exercised but would have cost him the premium. Had the deutsche mark appreciated substantially, however, he could have been far worse off for not hedging. In either case, moreover, by not covering his position he incurs an ex-ante exchange rate risk, something he presumably would prefer to avoid if he is risk averse.

Alternatively, the US importer could have hedged his foreign currency exposure by purchasing deutsche mark in the forward market. For example, suppose that the forward deutsche mark exchange rate against the US dollar was DM 3.06 per dollar. Had the importer covered his position through a forward purchase, he would have locked in the cost of $10.1 million (DM 31 million divided by DM 3.06/$) for the machinery, and subsequent exchange rate movements would have no bearing on this cost. Subsequent spot rate movements would, however, influence the cost when an option contract is used. So at different future spot rates, either the option or the forward contract would prove to be more advantageous than the other. In the example, at an exchange rate of DM 3.10/$ or below (an appreciation of the deutsche mark from its initial level), the cost (including the premium) would be $10.2 million with an option contract—higher than with outright forward cover. At an exchange rate of DM 3.14/ $, the option and the forward contract would yield the same cost of $10.1 million (DM 31 million divided by DM 3.14/$ plus $200,000 for the premium). And for an exchange rate above DM 3.14/$ (a depreciation of the deutsche mark from its initial level), the cost would be lower under an option contract. Whether using the forward market is a less costly alternative than the options market depends, ex post, on the realized value of the spot exchange rate. (It also depends, of course, on the size of the premium as well as on the striking price of the option contract and on the forward rate at the time that the transaction is undertaken.) In an ex-ante sense, whether an option is preferable to a forward contract as a means of hedging foreign currency exposure will likely depend on judgments regarding the future movements of the exchange rate. The added flexibility associated with an option contract can make it a preferred way of hedging, as it allows its holder to benefit from favorable exchange rate changes.

In the options market it is the premium that is determined by market forces and there is generally a choice of different striking Prices, each striking price associated with a different premium, while in the forward (or futures) market the exchange rate is market determined.

The foreign currency option contracts traded on the Chicago Mercantile Exchange differ from those traded on the other exchanges. The contract traded in Chicago since January 1984 is an option on a DM 125,000 futures contract, and since February 1984 options on £25,000 and Sw F 125,000 futures contracts. A Chicago foreign currency option, say on deutsche mark, gives the right to buy or sell a DM 125,000 futures contract at any time up to the option’s expiration date at the option’s striking price. In other words, the holder of the option contract would receive or provide for delivery of a futures contract in the currency rather than delivery of the foreign exchange itself. Since futures prices are closely correlated with spot exchange rates, an option on a foreign currency futures contract can be seen to be as effective a hedging device for most purposes as an option on foreign currency itself. The expiration dates are once again in March, June, September, and December, but the options expire 12 days before the expiration of the underlying futures contract (on the third Wednesday of the contract month).

In conclusion

Because an option contract entails a right rather than an obligation, foreign currency options not only limit the risk to their holders from adverse movements in exchange rates, but also permit gains from favorable rate movements. Options are particularly useful for hedging uncertain receipts and payments in foreign currency. While foreign currency options do not eliminate exchange rate risks altogether, they do add another dimension to the ways in which economic agents can transfer such risks from one agent to another.

In addition to over-the-counter, or customized, foreign currency options, standardized contracts are available and are traded on a number of organized exchanges. Trading volume in options traded on exchanges has grown markedly, and it appears to be in the process of further expansion. At the same time, an interbank market in options has been developing, facilitating increased bank services to customers and complementing trading on exchanges.

Several factors could support the future development of the foreign currency options market. Growth in international trade could further add to the commercial demand for foreign currency options. The continuation of volatility in exchange rates is another factor, as it tends to stimulate demand from both speculators and hedgers seeking new or additional tools with which to manage exchange risks. In addition, the use of foreign currency options is likely to grow simply because of rising familiarity with the instruments; the more the people use options and become comfortable with them, the larger the market is likely to become.

Investing in Development

Published by Oxford University Press for the World Bank

Lessons of World Bank Experience

by Warren C. Baum and Stokes M. Tolbert

Investing in Development is a guide for officials and others—in developing and industrial countries alike—who are concerned with development policy and selecting, preparing, and carrying out investment projects.

It brings together nearly four decades of World Bank experience in financing development projects throughout the world. A wealth of case studies illuminates the vital concepts, issues, and problems presented by the authors.

“The Bank is not just another financial institution. It is an international development agency whose thinking and ambitions are encapsulated in … Investing in Development,”

The Economist, September 14, 1985

For more complete information, see the special feature beginning on page 25 of this issue of Finance & Development.

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