Table of Contents

Question: ......................................................................................................................................... 2 Introduction ..................................................................................................................................... 2 Options ........................................................................................................................................ 2 Common Terminology used in Options ...................................................................................... 2 Currency Option .......................................................................................................................... 3 Forward Contract......................................................................................................................... 4 Futures Contract .......................................................................................................................... 4 Circumstances ................................................................................................................................. 5 Static:........................................................................................................................................... 5 Bullish Markets: .......................................................................................................................... 5 Bearish Markets: ......................................................................................................................... 6 Advantages of Options Trading ...................................................................................................... 6 Disadvantages of Options trading ..................................................Error! Bookmark not defined. References ....................................................................................................................................... 8

Question:
Explain what is meant by a currency option and critically discuss the circumstances in which an option might be preferred to a forward or futures contract as a component of hedging strategy.

Introduction
Options
In finance, whenever a financial instrument gives the right to owner to undergo some transaction but not the obligation on an asset at an pre agreed price on a pre agreed date is called Options. Here the owner has the right to undergo on such transaction but the there is no compulsion associated to the contract. Options are nothing but the derivative instrument whose value is derived from other underlying asset. Here the underlying asset can be bond, stock, future contract etc.

Common Terminology used in Options

Call Option- Call option is the option of buying something. It is also called as Call. In this type of option the buyer has the right but not the compulsion or obligation to buy the underlying asset. Put Option- Put option is a type of option to sell the underlying asset. It gives the right to the holder but not the compulsion of selling the underlying asset at the predetermined date and price. In the put option if the buyer exercises its right then the seller has to buy the underlying asset from the option buyer at the agreed strike price, no matter what is the current market price of that underlying asset. Spot price- It is the price at which the asset is traded currently in the market. Strike price- It is the price at which the deal has been made or the stock is traded. Exercising an option- If the option is activated which is agreed on a specific price on the trading of the asset is known as exercising the option.

Expiration date- Most of the times the options have some expiration date, after which the option is treated as expired. If the option is not exercised till the end of expiration date, the option becomes worthless and void. Premium- In lieu of granting the option the buyer pays an amount to the originator of the option. This amount is called the premium.

Currency Option
As we have discussed above the various aspects of options, in the same way currency option is also a contract that gives the option owner the right to but not the obligation to enter into the transaction. The only difference is that in currency options the underlying asset is foreign exchange rather than stock or bond. The basic concept of the currency option is the same in which the option buyer has taken the right in lieu of a specific amount (which is called premium) but not the obligation to engage himself into the contract. In all the currency transactions, one currency is bought and the other is sold at a specific price. We have already discussed the concept of call and put option in general. In currency option, the principle of call and put option is just the same. For example, an option to buy US dollar for Malaysian Ringgit is an USD call and RN put. Similarly an option to sell US dollar for RN is an US dollar put and RN call. The price quoted by the option seller at a particular time represents the agreement on options current value which has two elements i.e. intrinsic and time value. Intrinsic Value- Intrinsic value is nothing but the difference of spot price (current market price) and the strike price (price at which the underlying asset is traded). A put option will have intrinsic value only if the strike price is greater than the spot price. In the same way a call option will have the intrinsic value only if the spot price is greater than the strike price. The options (both put and call) if have positive intrinsic value are also called in the money.

Time Value- Time value of the currency constitute of five elements. These are a) Spot price (underlying price) b) The volatile nature of the underlying currency

c) The exercise price d) Time of expiration e) Difference in the "risk-free" rate of interest that can be gained by the two underlying currencies Due to the time value the price of put or call option is greater than its intrinsic value. The time value tends to zero as the expiration date of the option approaches. If the options current value consists of only the time value it is known as out of the money. Black-Scholes and CoxRubinstein models have been used widely in order to find the option pricing. Garmen-Kohlhagen model is another one to determine the currency option valuation.

Forward Contract- Also known as Forward, is the non-standardized contract between two
parties to undergo buying and selling of an underlying asset at a specific future date at an agreed price decided today. In other words we can also say that it is opposite of spot contract in which the agreement for buying and selling of the underlying asset happens today. Unlike options here the premium is not paid by any party. The objective of buyer and seller are different. The party agreeing to buy the underlying asset in the future takes a long position which means the holder owns the underlying asset and will get the profit if the price of the same goes up in the future. There is no clearing house guarantee involved in here and which means the parties could even default also the settlement of the contract occurs at the end of the contract only.

Futures Contract- Also known as Futures, is the standardized contract between two parties to
undergo buying and selling of an underlying asset at a specific future date at an agreed price decided today. These are a type of derivative contract where in the price of the underlying asset is determined by its current demand and supply. In futures the third party agreement to buy the underlying asset assumed to be a long position. Futures contracts are exchange traded that is why these are standardized contracts. There are clearing houses which are mediators between the parties and guarantee the transactions. Also these are marked to market prices and change on daily basis.
Circumstances in which an option might be preferred to a forward or futures contract as a component of hedging strategy.

Circumstances
Circumstances when Options might be preferred to a forward or future contract of hedging strategy are as listed below Let us consider three cases of movement of market static, bullish and bearish.

Static:
When the market is not at all moving and remains static in prices. Markets here mean the underlying assets of the options we are talking about. In such situation if a portfolio is hedged by using options and another portfolio is hedged by using say futures contract then as the market has remained constant the loss in case of futures or forward contract would be of brokerage amount whereas the loss in case of options will be of premium. As the options gives the holder the right to buy or sell the underlying asset and not the obligation the options are costlier than future and forward as in case of futures and forward contracts the obligation is there to enter into the transaction at the time of expiration they will must be executed at that time. The premium attached to the both call and put options could be a loss for the holder which will be higher than the brokerage of future and forward contracts. So in this situation where markets are expected to remain constant which is very unlikely the future and forwards contracts are better suited choice than option for hedging your portfolio as the losses will be limited and the cost involved will also be less. Limiting the potential losses means proper hedging strategy is used.

Bullish Markets:
Here the markets are going up the direction in which it will be helpful for your portfolio to grow. The options hedging is preferred over futures or forward contracts as the upward movement of markets the future fixed strike price of futures and forward contracts will limit the gains. So the futures and forwards nullify the portfolio positive movement and the overall gain of the portfolio become almost nil. Whereas in case of options the forward rally of the markets the holder of the option may not exercise it and loose premium but the upward rally will increase the underlying asset value which will increasing and the overall portfolio will be in positive gains. Thus in this situation where the markets are expected to rally upwards that is in bullish market expectations the preferred hedging choice would be option compared to futures and forwards.

Bearish Markets:
Here in the third case the markets are going in the adverse direction for your portfolio which means the value of your portfolio is going down and you are in losses. In such situation the underlying assets of the futures and forward contract will let you limit your losses or even make some gain over the current market price as the strike price will be equal to the market price or higher but definitely not lower than the market price. Whereas in case of options the options the underlying value of the assets are going down for sure with the market price and thus been there no obligation to exercise option the option may gets expired unexercised the maximum loss from hedging option could will be the cost of premium which will be more than the loss occurred from the futures and forward contracts. Also in this situation the losses with the options hedging could be limitless. So the futures and forward contract are preferred over option in bearish markets.

Advantages of Options Trading

There are following advantages of options trading Flexibility: Options provide investors a great deal of flexibility from conservative limit loss strategy to high risk and high gain strategy. It could be modified and used for more return than simply the stock price going up and down. Leverage: The investors could leverage their portfolio without entering committing trade by using options. Limited Risk: The risk associated in options trading is limited to the premium amount (except to the condition when writing options to the securities which are not owned). So the gains are unlimited and losses are limited to the premium. Hedging: The option allows investors to protect their position of long or short against the price or market fluctuations.

Disadvantages of Options trading

The options trading have following disadvantages which makes them some time (as described above) not preferable over the futures and forwards contracts.

Costs: The costs of trading in options is higher than the trading in underlying assets or futures or forward contracts as the commissions, bid and ask spread are significantly higher and additional premium costs are also involved.

Liquidity: The strikes prices available for options are too many in umber and this makes the low liquidity in the market. When the arbitragers enter into the market they solve the problem of liquidity as they pump in huge amounts of money in the market.

Complexity: As Options have certain complexities in terms of its trading as well as options requires a great amount of patient look of market and maintenance of portfolio. The combination of different instruments with option for hedging portfolio it becomes very complex to remain in profitable situations.

Time Decay: It has been observed that options time bound in nature as they have a fixed time until when they should be exercised. The main motive of the Call option writer is in making the options worthless to be in the profits. So most of the options expires worthless. The persons who are selling the option collects premium but the risk involved in it could be unlimited.

Unlimited Risk: The writing of uncovered options is subject to unlimited risk.

References
1) 2) Risk management and Option [http://www.islamic-world.net/economics/arbbun_01.htm] Chetan Jain, Currency Options [http://www.iimcal.ac.in/community/finclub/dhan/dhan7/CURRENCY%20OPTIONS.pd f] 3) What is Options Trading [http://www.zeromillion.com/financial-services/options-tradingadvantages-and-disadvantages-by-tim-wreford.html] 4) Circumstance of Options Preference over Futures and Forwards [http://www.linkedin.com/answers/financial-markets/futuresmarkets/MKT_FUT/503833-18743273] 5) 6) 7) McDonald, R.L. (2006) Derivatives markets. Boston: Addison-Wesley Taylor, Francesca. (2007). Mastering Derivatives Markets. Prentice Hall Anuradha Sivakumar and Runa Sarkar, Corporate Hedging for Foreign Exchange Risk [http://www.iitk.ac.in/infocell/announce/convention/papers/Marketing,%20Finance%20a nd%20International%20Strategy-07-Anuradha%20Sivakumar%20Runa%20Sarkar.pdf] 8) About Hedge Funds, [http://www.magnum.com/hedgefunds/abouthedgefunds.asp]