Chapter 6 Slides – Orange Coloured Slides

Slide 1:
 Last week we learnt about capital structure linking to theory of
repatriation tax & foreign tax credit. This week, we will be learning about
currency options.
 Delta hedging in options trading: not related to final exam.

Slide 2:
 The difference between an option and forward is that a forward is an
obligation/promise. If you make a promise, you have to keep it otherwise
you go bankrupt.
 Option is a right. It is up to you whether you want to exercise the option
if you want. You can exercise the option if it makes you a profit. You
don’t have to exercise if you are going to make a loss.
 Call option: gives the holder the right to purchase an asset
 Put option: gives the holder the right to sell an asset

Slide 3:
 This is an example to show the difference between a forward, call option
and put option.

Forward contract: Buying Underlying Asset

 1. In this case, they share the same the underlying asset is 1000USD.
The exercise/strike price is given as USD1.0/AUD and the maturity is 1
year.
 If you make a forward contract to buy this underlying asset of 1000USD
at time 0. The obligation to carry out the forward contract is in 1 year’s
time. Foreign exchange rate is given as 1.0 and therefore in other words
you have to pay 1000AUD at time 0.
 Suppose at time 1, the spot exchange rate is 1.0. If you sell the
1000USD back to the price market, you will receive 1000USD.
 Therefore, net payout from the forward contract is 0.

 2. However if the exchange rate is AUD1.1/USD. When you sell 1000

USD in the currency market, you will receive 1100AUD because the
spot exchange rate is 1.1. If you add these two cashflows together the
net payout from the forward contract is 100. We are talking about
forward contract to buy the underlying asset. A call option is given as a
right to buy an underlying asset. In this case, we are going to exercise
this call option, which has the right to buy 1000USD at 1000AUD, then
you are able to make 100AUD profit. Therefore, if you exercise this call
option, you will make a profit.

 3. If the exchange rate happens to be 0.9. Then, the amount decreases

to 900. The net payout will decrease to -100AUD. You would have to
pay 100AUD in the forward contract. If you make a forward contract
then it’s an obligation you have to keep. The call option is ok because
 you can just give away the option to exercise, as it is not an obligation,
as you don’t have to use the right. Therefore, the call option payoff is 0.
 If the net payoff from the forward contract is positive, then the call option
payout will have the same cashflow as the forward contract cashflows
as they involve the same transactions (buying the underlying asset). If
the payout of the forward contract is negative, the call option payout is
0.

Forward contract: Selling Underlying Asset

 The first example was buying the underlying asset, but now in this new
forward contract you are going to sell the underlying asset of 1000USD.
 1. If the spot exchange rate = 1.0, you will receive 1000AUD.
 2. If the exchange rate = 1.1. Then at time 1, you will pay 1100AUD, to
buy back the USD. You cancel out the selling side of the forward
contract. Therefore, the payout is -100AUD. The signs are different as
the transactions are different, as you are now selling the underlying
asset. The net payoff form the forward payoff is negative. If you exercise
this put option you will make a -100. For the put option payoff, you don’t
want a loss so you will give it away resulting in a net payoff of 0.
 3. If the exchange rate = 0.9, you are able to receive 100AUD more than
the market price, therefore you are able to make a profit of 100AUD by
exercising this put option of being able to sell at 1.0.

Call Option

If you generalise this relationship:

N
 N = Nominal Amount e.g.
NxK 1000USD
 K = Exercise/strike price
 Spot exchange rate at maturity is
N x ST given as ST.
N
Call Option
If you make a forward contract to buy N,
N (ST - K) the underlying asset, you are going to
pay N x K and if you sell the asset in spot
Put Option market, you receive N x ST. N (ST - K) =
Net payoff when buying underlying asset.
Important: When the payoff of the
NxK forward contract is negative, then the call
N option payoff is 0.

Put Option
N Reversal of the signs
N (K - ST) = Net payoff
N x ST Important: When the payoff of the
forward contract is negative, then the put
N (K - ST) option payoff is 0.
Slide 4:
 If you draw a graph of these payoff functions, you get these graphs.
 Strike price is given as 1.0. If the exchange rate at maturity is equal to
strike price, the net payoff is 0.
 The underlying value of the asset will increase with the spot rate at
maturity, which means the payoff from the forward contract to buy the
underlying asset will increase too.
 If the payment of the forward contract is negative, the payoff from the
call option becomes 0. Same thing goes for put option too.
 If you buy a call option, there must be a seller. The seller will pay what
the buyer receives. If you buy an option, there is always an upside
probability, no chance of loss. If you sell an option, there is only a
downside potential. However there is never “free lunch”.

Slide 6:
1. NPV of every transaction has to be zero. If you buy an option, there is
only upside potential, but you have to pay a price, which is known as the
option premium.

2. Suppose spot exchange rate is 1.0. Baseline scenario: exchange rate

will either move up or down by 10% with 50% chance probability. This
means it can be either 1.1 or 0.9.

Slide 7:
 If the exchange rate = 1.1, then the call’s payoff will be 100 and the
put’s payoff will be 0.
 If the exchange rate = 0.9, then the call’s payoff will be 0 and the put’s
payoff will be 100.
 NPV is defined as the sum of discounted future cashflows. You use
this equation to determine the option premium. The interest rate of 4% is
used to discount the cashflows.
 Option premium will be 49.80 in both situations.

Slide 8: Exercise Price

 The exercise price in the baseline scenario was given as 1.0. However,
the K in the equations changes to AUD 1.05/USD.
 If you estimate the value of the call and put option, the call’s value
decreases to 24.90 and the put’s value increases to 74.70.
 If exercise price goes up, call option price goes down and put option
price increases.

Slide 9: Volatility
 Exercise price is the same.
 Volatility as the exchange rate moves up or down by 20%. The new
possible exchange rates are 1.2 and 0.8.
 Both the new call and put option premium is 99.60.

Slide 10:
 The maturity of option is now 2 months and not 1 month.
  There is ¼ probability you will reach the top exchange rate of 1.21.
There is ½ probability you will reach the middle exchange rate of 0.99.
There is ¼ probability you will reach the top exchange rate of 0.81.
 Therefore the new premium is 52.08.
 When time to maturity increase, the price of both call and put options
will increase.

 Which out of the three parameters is most important in practice?

Volatility is the hardest to estimate. If you look at call option, everyone
has same detail and type of information in regards to exercise price and
time to maturity. Volatility is not observed in the real world. You have to
estimate using past or historical results. It is where you can take
advantage over other competitors.

Slide 11: How to use options to leverage trades

 Suppose that spot exchange rate is 1.0 and total wealth is 1000AUD,
which can be used on the currency market.
 Refers to slide 8.
 Strategy 1: Buy and hold 1,000 USD in cash, using the spot exchange
rate of 1.0.
 Strategy 2: The call option premium is given as 50 without discount. The
nominal amount of this contract was 1000 USD. However, you are able
to buy up to 20000 USD at maturity if you buy in call options.
o 1000/50 = 20
o 20 x 1000 = 20000

Slide 12:
In one month, if exchange rate moves up to AUD1.1/USD.
Strategy 1: 1000 x 1.1 = 1100 AUD, which gives a 10% return.
Strategy 2: The payoff form the call option is equal to 2000. Now your
investment return is 100%.
 Options are like borrowing money from the bank to buy more assets.

Slide 13:
 We have already learnt 4 ways of hedging currency risk exposure
 Renegotiation
 Sell project in secondary market
 Use money market
 Use forward contract

 How to use option to hedge this risk

 If the exchange rate happens to be 1.2, then the value of your
cashflow of 10milUSD will equal to 12milAUD.
 If the exchange rate happens to be 0.8, then the value of your
cashflow of 10milUSD will equal to 8milAUD.
 If you use put option to sell 10milUSD.
 The reason you are using a put option is because you going to receive
a positive cashflow of USD. You have to cancel this positive cashflow
through selling.
  When the exchange rate is 1.2, you don’t need to exercise the put
option but when the exchange rate is 0.8, you will exercise the put
option, which will give you another 2mil and therefore increase your
cashflow from 8mil to 10mil.
 Uncertainty remains, as you cannot make a perfect hedge.
 You can therefore avoid and limit downside potential and personal
responsibility.

Chapter 6 Slides – Blue & White Coloured Slides

Slide 2:
 Suppose you have negative cashflow of 1million Pounds in time 1.

Slide 3:
 You have to make forward contract to hedge the above underlying asset
(-1,000,000 Pounds). In this forward contract you are going to buy
1million British pounds in the future to hedge the exposure. As a result
the value of this contract is given by this graph.

Slide 5:
 CME is the largest exchange for options.
 The exercise price of this option will be 1.6. This is a call option.
 There are 2 types of options: American (you can exercise whenever you
want even before maturity) and European (you can only exercise at
maturity). It is actually not optimal to exercise early as option has time
value with maturity.
 Nominal amount of the contract is 62,500 pounds.

Slide 6:
 The first column shows exercise price from 1.58 to 1.62.
 Example to buy a call option: To buy one British pound in October at the
exercise price of 1.6, you have to pay 8 cents.
 Table has price of call and put options in cents.
 High maturity implies higher price.

Slide 7:
 For call option, when exchange rate is higher than exercise price, it is ‘in
the money’. When exchange rate is lower than exercise price, it is ‘out
of the money’. For put options, it is the opposite of these relationships.

Slide 8:
 Typo: they have used the October exercise price but they should have
used December prices. Revised number below.
  Suppose option premium is given as 8cents. 8cents x nominal amount
of 62,500 = 5000 at time 0.
 Option premium = ($0.08/£)(£62,500) = $5,000 (cost to buy)
 Exercise price = ($1.60/£)(£62,500) = $100,000 (cost to exercise)
 If you sell the Pounds back to money market, you will receive £110,000.
 Long is about buying and short is about selling.

Slide 11:
 You can switch a call and put option with each other.

Slide 12:
 If you combine a long call and short put, you get the same result as a
long forward.

Slide 13: Put-call parity at expiration

 Call – Put + Risk free asset = Underlying asset
 Call = Put + Underlying asset – Risk free asset
 Basic strategy is to buy something cheap and sell high.
 In the second portfolio, it will give you the same payout as the call option
(also called the synthetic call option). If the call option is higher than the
number in the above relationship, you take a short position of call option
and long position of the portfolio.
 Same method for puts and underlying asset.

Slide 15:
 A option value has two components: Intrinsic value and Time value
 Time value is always positive as the upside potential dominates.
 This is why it is not optimal to exercise American option to exercise
before maturity, as you will sacrifice time value of money. You would
prefer to sell to outside investors instead of exercising to receive time
value of money.

Slide 17: Interaction of time and volatility

 Var (X1 + X2) = Var (X1) + Var (X2) if X1 and X2 are independent.
 The above relationship supports this equation, sT2 = T s2
 This works for stock market but not for the currency market.
 Whenever there is a financial crisis, it jumps and recovers. If exchange
rate increases today, then tomorrow’s exchange rate is likely to
decrease. This is known as mean reversion.
 For currency market, today’s exchange rate movement is not
independent from previous movements and so the relationship doesn’t
work.
Slide 18:
 If you short both put and call, you will create a straddle strategy.
 By selling both the put and call option, you will receive a premium from
both.
 The blue line is payout from the short put position.
 Straddles are normally classified into 7 categories. In good times, this
strategy creates profit around 70-80% of the time of 20%. Whenever
there is crisis, they lose lots of money and go bankrupt. There is no limit
to the downsides.
 Barings bank: They were founded in 1762 and even lent money to
British government but became bankrupt because of Nick Leeson, who
is an example of a rogue trader. He used this straddle strategy in
Japanese market, but there was a earthquake in Japan. Barings Bank
was sold to ING for 1pound.

Slide 26:
 Black Scholes equation assumes that the volatility doesn’t change.
 Before the Lehmann Brothers bankruptcy, VIX increased. It means the
volatility is changing all the time.

1. Binominal tree
2. Monte Carlo simulation