Transcript C H A P T E R 5

FINC3240
International Finance
Chapter 5
Currency Options
1
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.
2
Two types of options:
Call vs. Put options




Call option
Gives holder the right to buy an asset at a
specified exercise price on or before a
specified expiration date.
Put option
Gives holder the right to sell an asset at a
specified exercise price on or before a
specified expiration date.
3
Exercise price

Exercise price
• 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.

Exercise price is also called the strike
price.
4
Option premium




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 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.
5
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, 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
The long and short

If you buy an option, then you are
• “long the option” or “long option” or you have a
“long position”.

If you sell an option, then you are
• “short the option” or “short option” or you have
a “short position”.
Example: if you buy a call option, you are “long call”.
7
Options Features
There are always two positions in each
option contract:
Long for the buyer vs. Short for the seller
(1)
(2)
(3)
(4)
Buying a Call → Long a Call
Selling a Call → Short a Call
Buying a Put → Long a Put
Selling a Put → Short a Put
8
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
Options trading (1)

1.
2.
Option contracts are traded in two
types of markets:
Over-the-counter (OTC) markets
Exchanges, such as:
• Chicago Board Options Exchange
(CBOE)
• Chicago Mercantile Exchange (CME)
• International Securities Exchange
 Option Clearing Corporation (OCC)
10
Options trading (2)
1.
2.
OTC
Option contract
can be
customized to
needs of trader.
Difficult to trade.
Secondary market
illiquid.
1.
2.
Exchanges
Option contracts
are standardized
by maturity dates
and exercise
price.
Easy to trade.
Secondary market
is liquid.
11
Options on IBM June 7, 2004
Source: Wall Street Journal Online Edition, June 8, 2004.
12
Underlying asset


Individual stocks
Stock market indexes
• S&P 100, S&P 500, DJIA, Nikkei 225,
FTSE 100 etc.
Futures
 Foreign currency
 Treasury bonds, Treasury notes
And many others.

13
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.
14
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.
15
American vs. European options


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.
16
Payoffs of a Call Option
Long Call at $20
Short Call at $20
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0
5
10
15
20
25
30
35
40
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
5
10
15
20
25
30
35
40
17
Profit/Loss of a Call Option
Long Call at $20
Short Call at $20
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0
5
10
15
20
25
30
35
40
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
5
10
15
20
25
30
35
40
18
Profit/Loss of Long and Short on
Call Option
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0
5
10
15
20
25
30
35
0
40
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
5
10
15
20
25
30
35
40
19
Payoffs of a Put Option
Long Put at $20
Short Put at $20
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0
5
10
15
20
25
30
35
40
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
5
10
15
20
25
30
35
40
20
Profit/Loss of a Put Option
Long Put at $20
Short Put at $20
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0
5
10
15
20
25
30
35
40
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
5
10
15
20
25
30
35
40
21
Profit/Loss of Long and Short on
Put Option
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0
5
10
15
20
25
30
35
40
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
5
10
15
20
25
30
35
40
22
Call Option’s Payoff/Profit at Expiration

Payoff for a Long Call:
ST  X if ST  X
0
if ST  X

Profit for a Long Call: payoff – option premium

Payoff for a Short Call:
 (ST  X ) if ST  X
0

if ST  X
Profit for a Short Call: option premium + payoff
23
Put Option’s Payoff/Profit at Expiration

Payoff for a Long Put:
X  ST if ST  X
0
if ST  X

Profit for a Long Put: payoff – option premium

Payoff for a Short Put:  ( X  ST ) if ST  X
0

if ST  X
Profit for a Short Put: option premium + payoff
24
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?
Profit/Loss = 5 + [-(30-20)] = 5 -10 = -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?
Profit/Loss = (30-15) - 5 = 15 - 5 = 10
25
Call option:
Payoff & Profit at expiration

1.
2.
3.
4.
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.
Are you better off exercising the option?
What is the payoff from the option exercise?
What is the profit from the option exercise?
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.
26
Payoff & profit diagram of call
option holder at expiration
14
12
cost of option
Payoff/ profit
10
8
Payoff
6
4
Profit
2
0
Stock price at expiration
-2
Break even point
-4
-6
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
call payoff
0
0
0
0
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
call profit
-5
-5
-5
-5
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
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Payoff & profit diagram of call
option writer at expiration
10
Profit
5
Break even point
Payoff/ profit
option premium
0
Stock price at expiration
Payoff
-5
-10
-15
-20
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
call w riter payoff
0
0
0
0
0
-1
-2
-3
-4
-5
-6
-7
-8
-9
-10
-11
-12
-13
-14
-15
call w riter profit
5
5
5
5
5
4
3
2
1
0
-1
-2
-3
-4
-5
-6
-7
-8
-9
-10
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Call Review

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.
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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.
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.
30
Payoff & profit diagram of put
option holder at expiration
10
8
Payoff/ profit
6
Payoff
4
2
Break even point
Stock price at expiration
0
option premium
-2
-4
Profit
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
put payoff
10
9
8
7
6
5
4
3
2
1
0
0
0
0
0
0
0
0
0
0
put profit
7
6
5
4
3
2
1
0
-1
-2
-3
-3
-3
-3
-3
-3
-3
-3
-3
-3
31
Payoff & profit diagram of put
option writer at expiration
4
Profit
Break even point
2
option premium
Payoff/ profit
0
Stock price at expiration
-2
Payoff
-4
-6
-8
-10
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
put w riter payoff
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
0
0
0
0
0
0
0
0
0
put w riter profit
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
3
3
3
3
3
3
3
3
3
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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?
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.
33
Practice Questions
To be assigned on the course website
34
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.
35
Moneyness (2)
ST < X
ST = X
Call options Out of the At the money
money
Put options
In the
money
At the money
ST > X
In the
money
Out of the
money
36
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 ST, the stock price
on the expiration date?
a.ST > $50
b.ST > $70
c.$70 > ST > $50
d.ST < $50

37
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 ST, the stock
price on the expiration date?
a.ST < $20
b.ST < $35
c.$20 < ST < $35
d.ST > $35

38
How to close a position?

1. reverse trading before expiration

2. execute the option

3. wait for expiration
39
Protective Put Strategy


Portfolio consisting of a put option
and the underlying asset.
Guarantees that minimum portfolio
value (payoff) is equal to the put’s
exercise price.
40
Protective put:
Payoff & profit at expiration
S0 = initial asset price, and
P = put option premium.
Cost of the position = asset price + put premium
= S0 + P
Payoff of stock
Payoff of put
Total payoff
Profit
ST ≤ X
ST
X – ST
X
X – (S0+P)
ST > X
ST
0
ST
ST – (S0 + P)
41
Payoff & profit of protective
put position at expiration
42
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.
2.
The buyer of a Call option has the right, not the
obligation, to buy a currency.
The buyer of a Put option has the right, not the
obligation, to sell a currency.
http://www.cmegroup.com/trading/fx/g10/euro-fx_contractSpecs_options.html#prodType=AME
43
43
Contingency (payoff) Graphs for
Currency Options
1. Contingency
Call Option
2. Contingency
Call Option
3. Contingency
Put Option
4. Contingency
Put Option
Graph for a Buyer of a
Graph for a Seller of a
Graph for a Buyer of a
Graph for a Seller of a
44
Contingency Graphs for Currency Options
Insert exhibit 5.6 page 123
45
Currency Call Options Premium

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
Currency Put Options Premium

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
Call Options Application

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
Call Options Application



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 $0.9090.
Pike Co. buys 10 A$ Call options on March 1 and
pay premium of $0.0150.
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 A$1.050, Pike executes the options and
buy A$ at the strike price, $0.9090.
49
Put Options Application
Hedge receivables



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 $0.9500.
ABC Co. buy 200 C$ Put options on March 1 and pay
$0.0100 premium.
On September 28,


If the spot rate is $0.9400, ABC executes the options and
sell C$ at the strike price, $0.9500.
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
Speculation with Call Options (1)
example on page 137, Mr. Jim






Strike price=$1.4000/BP
Settlement date=December, 31
Contract amount=31,250 BP
No brokerage fees.
Jim buys one Call option on June, 1 with premium of
$0.0120/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?
(1.4100-1.4000-0.0120)/BP more details in the textbook 51
Speculation with Call Options (2)
Q&A 19



Call option premium=$0.03/C$
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.
Possible spot rate of
C$ on expiration date
$0.76
0.78
0.80
0.82
0.85
0.87
net Profit (loss)/C$
-0.02
0.00
0.02
0.04
0.07
0.09
52
Speculation with Put Options (1)
example on page 140






Strike price=$1.4000/BP
Settlement date=December, 31
Contract amount=31,250 BP
No brokerage fees.
One investor buy one Put option on June, 1 with premium
of $0.0400/BP. Spot rate on June,1 =$1.3900
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?
(1.4000-1.3000-0.0400)/BP more details in the textbook 53
Speculation with Put Options (2)
Q&A 20



Put option premium=$0.02/C$
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.
Possible spot rate of
C$ on expiration date
$0.76
0.79
0.84
0.87
0.89
0.91
net Profit (loss)/C$
0.08
0.05
0.00
-0.02
-0.02
-0.02
54
Problems

An investor traded two options on euro. The first
call option has an exercise price of $1.050. The
second put option has an exercise price of
$1.100. Both options have the same expiration
date. Today is the expiration date. At what price
will the investor receive positive payoff from his
portfolio?
55
Protective put 1
S0 = initial currency price
P = put option premium
Cost of the position = currency price + put premium
= S0 + P
ST ≤ X
ST > X
Payoff of currency
ST
ST
Payoff of put
X – ST
0
Total payoff
X
ST
56
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.
(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
Homework 6

Chapter 5 Q&A:
6,7,10,11,12,13,21,22.
58