understanding forwards & options

7/21/2019 Understanding Forwards & Options

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UNDERSTANDINGUNDERSTANDING

FORWARDS &FORWARDS &

OPTIONSOPTIONS



Contract to sell or buy a currency at a rate agreed

today; for delivery at a pre-determined future date or

time period Difference between the spot and the forward rate is

called, forward points, swap points, or forward

margin. Outright forward rate = spot rate + forward points

Forward Contracts



Interest Parity Principle

etween two freely convertible currencies, the difference between the spot rate and the forward rate is determined by

the interest rate differential between the two currencies.

!pot " # $uro = #.%%%& '!D

( month )nterest *ates " '!D #. ; $'* #.((

(m Forward 1 Euro = 1. 3339 USD

!pot *ate )nterest *ate Differential /orward 0eriod

#11 2o. of days in the year 3or4 5onths in a 6ear

= #.%%%&3#.-#.((4( / #11#

= 1.1117

=



Interest Parity Principle....

orrow # $'* at #.(& )nt. payable 1.118%

!ell # $'* against #.%%%& '!D !pot)nvest #.%%%& '!D at #. )nt. receivable 1.1##7(

9o eliminate arbitrage today:s (m forward should be such that

'!D #.%77( = $uro #.118%

# $uro = 3#.%77(<#.118%4 = '!D #.%%%

To erify



Interest Parity Principle….

Currency with low interest rate will be at a premium

Currency with high interest rate will be at a discount

/orward rate is no indication of future spot rate



Calculation of Annualised Premiums

!pot <*e = *s. &1.%&

(5 - /wd.0remium = *s 1.(8

>nnuali?ed 0remium " 0remium #11 %(& !pot n

1.(8 #11 %(&

&1.%& #81

*esult " .%

n = 0remium period in days



Option Forwards (Time Options)

'!D )mports for @uly nd half

'!D<)2* = &1.% + 1.7%11 + anA:s 5argin

0remium charged up to %#<1<1

'!D $Bports for @uly nd half 3they will get only till #&th

@ul4'!D<)2* = &1.%& - 1.%%8 - anA:s 5argin

0remium provided up to #&<1&<1 = 1.%711 + 31.7#11-1.%7114 #&<%#

3>2 )! 9$ E)22$* )2 O9 9$ C>!$!4

!pot *ate &1.%& &1.%

%1 >pril 1.#1 1.#

%# 5ay 1.(

%1 @une 1.%7 1.%(

%# @uly 1.7# 1.7%

1.7



Cancellation

F On #st /eb-1, an eBporter sold #11111 for %1th @un 1

delivery G &1.&

! "ontract cancelled # mont$s before maturity

On %1<17, with the month forward rate from cancellation dateto %1th @un at say &#.11 the cancellation loss of *s.3&1114 i.e

3&#.11-&1.&4#11,1114 will be recovered from the customer.

!! %utomatic cancellation on t$e &t$ day from t$edate of maturity H)f a gain is made on cancellation, the gain

will not be passed on to the customer but the loss will of course

be recovered.



Excan!e Control aspects

9he customer can be given the facility of booAing a single

forward contract for several orders provided that the receivables are

in the same currency and the liAely cash flow period falls within the

same contract period.

$Bporters are allowed to deliver eBchange representing a portion

of the eBport value in part utilisation of the forward contract.



Managing

Risk

Using Option



Option

- contract were te u'er as te ri4t ut not teoli4ation to

* 6u'/,ell* ,peci%ied uantit' o% a currenc'* -t a speci%ied price "strie price* 6' a particular date "expir' date

For tis ri4t te u'er pa's te seller"writer o% te

option an up%ront %ee "called option preiu



Option "#s Forward

9 :ption 4i;e te u'er ari4t ut no oli4ation.

9 <ood instruent toed4e ad;erse price

o;es a;oidin4opportunit' loss.

9 p%ront preiu

9Can coose te strieprice

9 ,peci%ic date

9 Forwards are %ixed pricecontracts werein teu'er/seller is oli4atedto te price

9 :pportunit' loss

9 1o up%ront preiu

9 Cannot coose testrie price

9 :ption %orwards "tieoptions



Two types of option

American Option

5ay be eBercised at any time during the life of a contract.

European Option.

5ay be eBercised only at maturity or eBpiry date.



Option Terminolo!ies

Call Option

Jives the holder the right but not the obligation to

'U( an underlying at a fiBed price from the writer of

the option.

Put Option

Jives the holder the right but not the obligation to

SE)) an underlying at a fiBed price to the writer of

the option



%is& # Profit Profile

uyer Seller

!rofit Unli"ite# !re"iu"

Ris$ !re"iu" Unli"ite#



Option ' pecs

,trie ?rice or @xercise priceAe %ixed price at wic te option older as teri4t to u' or sell te underl'in4 currenc'.

@xpir' Date Ae last da' on wic te option a' e exercised.

Bi%e or @xercise ?eriodAe period o% tie durin4 wic te option oldereno's te purcased option contracts.



Option stri&e price

n te one' "A

Ae option is n te one' wen te ,trie ?rice is %a;ouraleto te option older"u'er tan te current %orward rate.

@4 ,D put option wit strie 50.00 E current %wd rate #).20 Eoption in te one'

:ut o% te one' ":A Ae option is :ut o% te one' wen te ,trie ?rice isun%a;ourale to te option older"/u'er tan te current%orward rate.

@4 ,D put option wit strie #5.00 E current %wd rate #).20 E

option out o% te one' -t te one' "-A Ae option is -t te one' wen te ,trie ?rice is eual to

te current %orward rate.



Price of an Option

Can te :ption u'er a;e te cae eat it too

1ot reall' * since te option seller car4es te u'er anup%ront preiu pa'ale in cas.

-nd te up%ront preiu can e as i4 as &G or e;en oredependin4 on te strie price and te aturit' period.



0.0000

0.1000

0.000

0./000

0.4000

0.5000

0.000

0.7000

0.8000

0.9000

4.05 4.15 4.5 4./5 4.45 4.55 4.5 4.75 4.85 4.95 47.05 47.15

!re"iu"

Intrinsi% &alue

'i"e alue

Te Premium of a Put Option di"ided into Time

*alue + Intrinsic *alue

Spot USD/INR 2 4.053# USD/INR2 4.55

>s the striAe of the put 3B-aBis4 increases, the premium goes up. /or an out of money put,

there is only time Kalue and no intrinsic value. >s soon as the striAe goes above the forward

rate 3i.e. option becomes )954, time value starts to come down and intrinsic value goes up.



Option premium $ ,uotations

0oints of the second currency<terms currency

or

0remiums are Luoted as a flat percentage of the base currency

principal amount



Factors determinin! Premium "alue

Holatilit'

,trie ?rice

Bi%e or @xercise ?eriod

nterest Rates * doestic %orei4n

Current aret Rate



0

0.005

0.0&

0.0&5

0.02

0.025

& 2 3 # 5 ! 7 8 ) &0

5 axis 6 &olatility in 7 8 axis 6 9ption !re"iu"

s

Can!e in premium wit can!e in "olatility



tri&e Price -ynamics

Ae option preiu can e uite i4 %or -A options.

s tere a wa' to reduce te preiu

There is one golden rule. You can’t get anything in the

market for free.

,o to reduce te preiu 'ou a;e to 4i;e up soeprotection.

Ao reduce te preiu 'ou a;e to raise te strie price

and consider u'in4 an :A option tere' 4i;in4 upsoe protection. Ae ore :A te option is te lowerwill e te preiu. Con;ersel' te ore A an optionis te i4er will e te preiu.



Option trate!ies



PAI/ *A/IA OPTIO/

F $Bporter H uy a '!D 0ut< )2* Call at &#.1%

F Cost H *s. #.1 per

F 5aturity H %1th !eptember 11

F !pot H &1.%1 /orward *ate H &#.1%

$Bplanation " On maturity

if '!D<)2* M &#.1% , corporate sells '!D at &#.1%

if '!D<)2* N &#.1% , Corporate sells at spot

T$e ma*imum loss in t$is structure is t$e cost +aid for t$e

o+tion and is ,nown u+front and t$e -ains are unlimited



E0 "ST 2T! ST0%TE4!ES

-n option u'er can reduce is preiu cost ' sellin4

anoter option. Ae coination can reduce te cost aste preiu recei;ed on te option sold could eiterpartiall' or %ull' o%%set te cost o% option ou4t.

Different Strate:ies2

&. Ran4e Forward

2. Re;erse Ran4e

3. ?articipatin4 Forward

#. Be;era4ed

5. Be;era4ed



%A/0E FO%1A%-

Definition " uy a '!D put < )2* Call at 7.71

!ell a '!D Call<)2* 0ut at &.11

5aturity " %1th

!eptember 11


if '!D<)2* M 7.71 , corporate sells '!D at 7.71

if '!D<)2* N &.11 , Corporate forced to sell at &.11

)f '!D<)2* is between 7.71 and &.11, then the corporate

gets the spot.



%E*E%E %A/0E

Definition " uy a '!D put < )2* Call at &.11

!ell a '!D Call<)2* 0ut at 7.&1

5aturity " %1th !eptember 11


if '!D<)2* M 7.&1, corporate sells '!D at &.11

if '!D<)2* N &.11 , Corporate forced to sell at 7.&1

)f '!D<)2* is between 7.&1 and &.11, then the corporate

sells at 7.&1+3&.11-!pot on maturity4P.



PA%TICIPATI/0 FO%1A%-

Definition " uy a '!D put < )2* Call at 7.&1

!ell a 1.& '!D Call<)2* 0ut at 7.&1

5aturity " %1th

!eptember 11


if '!D<)2* M 7.&1 , corporate sells '!D at 7.&1

if '!D<)2* N 7.&1 , Corporate forced to sell half of the

eBposure at 7.&1 and the balance at the spot.



E*E%A0E-

Definition " uy a '!D put < )2* Call at &#.&

!ell a '!D Call<)2* 0ut at &#.&

5aturity " %1th !eptember 11


if '!D<)2* M &#.& , corporate sells '!D at &#.&

if '!D<)2* N &#.& , Corporate forced to sell twice t$e

amount at &#.&



%upee Option ' Product specs

Hanilla @uropean options coinations tereo% atintroduction. Ais will continue till ans a;esopisticated s'stes ris ana4eent %raewors toed4e tis new non*linear product.

:;er te counter contracts.

Can e tailored to suit te corporateIs need.

1o iniu optional at recoended ' R6.

?reiu pa'ale on spot asis.



%upee Option ' Product specs..

,ettleent would e eiter ' deli;er' on spot asis ornet cas settleent in Rupees on ,pot asis dependin4on te FC*1R spot rate on aturit' date. "specs will e

speci%ied in te contract E R6 re%erence rate could e tere%erence rate %or settleent.

,trie ?rice aturit' could e tailored to suit

counterpartiesI needs E t'pical aturities are & wee2wees & 2 3 ! ) &2 onts.

@xercise st'le @uropean.



2ses of %upee option

Ao ed4e 4enuine FJ exposures arisin4 out o%trade/usiness "6ans a' oo transactions ased onestiated exposure %or uncertain aounts

Ao ed4e FC loans.

6alance in @@FC accounts.



9hanA 6ou

understanding forwards & options

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