Currency optionsIntroductionCurrency options have gained acceptance as invaluable tools in managing foreign exchange risk. They are
extensively used and bring a much wider range of hedging alternatives as a result of their unique nature. Options
are fundamentally different from forward contracts, as whereas the parties are committed or ‘locked-in’ to a future
transaction in a forward contract, the buyer (holder) of an option contract has the right, but not the obligation to
complete the transaction at some time in the future. Options are attractive financial instruments to portfolio
managers and corporate treasuries because of this s contractsSimply stated, an option contract is a choice. The holder of the option has the right but not the obligation to buy or sell a fixed amount of currency at a fixed rate of
exchange at a predetermined date in the future. It is entirely up to that buyer whether or not to exercise that right (that is take up the right of the option), only the seller
of the option is obligated to perform. The option holder (buyer) can therefore choose the better price – either from the prevailing market price at the time, or the price
specified in the option. An option can be regarded as a form of insurance; if the market moves against you, you will be protected and can still take advantage of better
prices should the market move in your of options contractsTwo types may be bought and sold:Call options give the buyer the right to buy the underlying currency. The holder of a call option has the right to buy the underlying currency, while the seller of the call
option has the obligation to sell the underlying currency if and when the holder thereof takes up the options give the buyer the right to sell the underlying currency. The holder of a put option has the right to sell the underlying currency, while the seller of the put
option has the obligation to buy the underlying currency if and when the holder thereof takes up the a foreign exchange transaction, one currency is bought, while another is simultaneously sold. An option to buy US dollars against the SA rand (USD Call) is an option to
sell SA rand against the US dollar (Rand Put). In every foreign exchange transaction, one currency is purchased and another currency is sold. Consequently, every currency
option is both a call and a ers:
Exporters:
Buy call If either option is exercised, Client buys currency
Sell putBuy call If either option is exercised, Client buys currency
Sell put}}Currency options may be quoted in one of two ways: American terms, in which a currency is quoted in terms of the US dollar per unit of foreign currency; and European
terms, in which the US dollar is quoted in terms of units of foreign currency per US dollar.A European style option may be exercised on the expiration date of the option only, while American style options may be exercised at any time up to and including the
expiration date.
Options terminology• Buyer (Holder): The owner of the option contract.• Premium: When options are bought, the premium (cost of the option) has to be paid at the time of purchase that is up front. The actual amount of the premium depends on a number of factors, which take into account how likely it will be that the option will be exercised (takes up the right
of the option). The premium is a percentage of the value of the underlying currency and represents compensation to the seller for the risk involved with the option
contract over the option period.• Exercise: To exercise the option means to call upon the right granted in terms of the option. The buyer (holder) will be the party exercising the option.• Strike price / Exercise price (Rate): This is the price (rate) at which the buyer (holder) of the option is entitled to either buy or sell the underlying currency. The strike
price is determined at the time the option is purchased.• Expiry / Expiration date: The final date at which the option may be exercised in terms of the option contract that is the day on which the option s pricing dynamicsAn option contract, from a buyer’s point of view is the same as buying an insurance policy. In the same way that insurance premiums are based on the probability of a claim
being made, the price of an option also represents the measure of risk which will be assumed by the seller of the contract. The option value or premium, can be split into
two components – Intrinsic value and Time value.
Intrinsic valueThis represents the amount of money, if any, that could currently be realised by exercising an option with a given strike price. For example, a call option has intrinsic value if
its strike price is below the spot exchange rate. A put option has intrinsic value if its strike price is above the spot exchange -The-Money: This term is applied to an option that has intrinsic value. That is when a profit can be realised upon exercising it. For a call option, it is the case when the spot
exchange rate is higher than the strike price of the option, and for a put option, when the spot exchange rate is below the strike -the-Money: A call option is said to be “out-of-the-money” if the underlying spot exchange rate is currently less than the strike price of the option. A put option is said
to be “out-of-the-money” if the underlying spot exchange rate is currently more than the strike price of the option. An option that is “out-of-the-money” at expiry will
have no value, and the holder of the option will allow it to expire -The-Money: This means that the strike price and the spot exchange rate are the same. Like the “out-of-the-money” option, the holder would allow the option to in table form:Option typeCallsPutsSpot exchange rate is greater than strike Spot exchange rate is equal to strike Spot exchange rate is less than strike
pricepricepriceIn-The-MoneyOut-Of-The-MoneyAt-The-MoneyAt-The-MoneyOut-Of-The-MoneyIn-The-MoneyTime ValueTime value is a little more complex. When the price of a put or call option is greater than its intrinsic value, it is because the option has time value. Time value is determined
by: the spot price; the volatility of the underlying currency; the exercise price; the time to expiration; and the difference in the ‘risk-free’ rate of interest that can be earned
by the two currencies. The time value of the option contract will diminish over the life of the option and at expiration will be zero. The time value portion of an option is at
its greatest when the option is “at-the-money:, that is the strike (exercise) rate is equal to the market rate. This is because the entire premium is equal to time value, as the
option has no intrinsic value.
Shown in table form:Option typeIn-The-MoneyAt-The-MoneyOut-Of-The-MoneySpot exchange rate is greater than strike Spot exchange rate is equal to strike
priceprice>50%50%<50%Intrinsic value plus time valueOnly time valueLess time value than “at-the-money”Key features of options1. Flexibility: Once a company has determined their risk management goals, options can very often be used to achieve them. The solution will always involve a risk vs.
return trade off and the company itself will determine the degree of protection required in respect of the premium involved and the benefits (or upside potential)
retained. Thus, the company has the ability to set the strike rate and the maturity to suit particular and specific requirements.2. Combining long and short positions: Long and short positions can be combined on put and call options to create pay-offs which specifically fit the underlying ationsExporterVanilla options: Buy USD Put / ZAR CallDefinitionWhy useWhen to useOpportunity costPremiumStrike levelsOptionality
An exporter acquires the right but not the obligation to sell a fixed quantity of USD at a specified rate on a specified protection against adverse movements in the exchange rate and introduces expectation that the spot rate may be above the forward rate at maturity. This strategy gives an Exporter protection
against an appreciating exchange rate while allowing unlimited participation in a depreciating exchange cost is limited to the premium paid while retaining unlimited potential m payable, value strategy is flexible and the exporter can set the strike at any level. Note: The higher the strike the higher the exporter has the right to enforce the contract to exchange currency for one another but will not exercise the option if it is
more beneficial to deal in the spot market.
ParticipationUSD Put / ZAR CallSpot:
Fwd:
Strike:
Premium:
5.90005.9700 (3 months)5.9700 (ATMF)
22.64 ZAR cents per USDSell USD @ SpotBreakeven: 6.19645.9700FWDBreakeven: 6.1964Worst Case: 5.7436
**************Worst case: 5.7436ProtectionOn maturitySpot rate higher than strike rate:Spot rate lower than strike rate:Breakeven definedThe option would expire worthless and would not be exercised. The exporter would sell USD in the spot market at the higher
rate and effectively receives the spot rate minus initial exporter would exercise the option and sell USD at the strike rate. The exporter effectively receives the strike rate minus
initial breakeven rate is the level of spot where the USD Put / ZAR Call outperforms forward cover. The exporter should hold
the view that he would realise a rate better than the breakeven level otherwise it would have been better to have hedged
via the an and AmericanTypesOther types of export optionsCollar: Export zero cost: Provides an exporter with a trading range, which protects against adverse appreciation of the currency, while limiting potential participation in
favourable depreciation of the currency. This provides flexibility in management of Export exposures. The collar offers a zero premium hedge where the spot rate is
expected to be higher than the forward rate at -up Option: Step-Up Forward: Allows an exporter to achieve an effective rate better than the forward rate. Used to achieve Export rates at a premium to the forward
rate. This structure suits an exporter with regular commitments and offers a fixed rate, which is higher then the current forward participation option: Allows for participation in favourable exchange rate movements. Provides protection and introduces flexibility. Use when your view is that the
spot rate may be above the forward rate at export collar: Provides an exporter with a range which protects against an adverse appreciation of the currency while limiting potential participation in a favourable
currency depreciation. Provides flexibility in management of export exposures. This structure suits an exporter with regular commitments and is applicable when the spot
rate is expected to be higher than the forward rate at erBuy USD Call / ZAR PutDefinitionWhy useWhen to useAn importer acquires the right but not the obligation to buy a fixed quantity of USD at a specified rate on a specified protection against adverse movements in the exchange rate and introduces the expectation is that the spot rate may be below the forward rate at maturity. This strategy gives an importer
protection against an depreciating exchange rate while allowing unlimited participation in a appreciation of the
exchange cost is limited to the premium paid while retaining unlimited potential m payable, value strategy is flexible and the importer can set the strike at any level. Note: The lower the strike the higher the importer has the right to enforce the contract to exchange currency for one another but will not exercise the option if it is
more beneficial to deal in the spot unity costPremiumStrike levelsOptionality
ProtectionUSD Put / ZAR CallSpot:
Fwd:
Strike:
Premium:
5.95006.0200 (3 months)6.0200 (ATMF)
22.87 ZAR cents per USD*****************Worst case: 6.24876.0200FWDBreakeven: 5.7913Worst Case: 6.2487
Buy USD @ SpotBreakeven: 5.7913ParticipationOn maturitySpot rate lower than strike rate:Spot rate higher than strike rate:Breakeven definedThe option would expire worthless and would not be exercised. The importer would purchase USD in the spot market at the
lower rate and effectively pay the spot rate minus initial importer would exercise the option and purchase USD at the strike rate. The importer effectively pays the strike rate plus
initial breakeven rate is the level of spot where the USD Call / ZAR Put outperforms forward cover. The importer should hold
the view that he would realise a rate better than the breakeven level otherwise it would have been better to have hedged
via the an and AmericanTypesOther types of import optionsStep-Up Option: Step-Up Forward: Allows importers to achieve an effective rate better than the forward rate. Used to achieve import rates at a discount to the forward rate.
This structure suits an importer with regular commitments and offers rates which are lower than the current participation option: Allows for participation in favourable exchange rate movements. Provides protection and introduces flexibility. Use when you take the view that
the spot rate may be below the forward rate at t detailsFor further information on any of our products or services:Forex Relationship Centre
Corporate and Investment Banking Division
Standard Bank
Toll Free Tel: 08000-FOREX(36739)
Fax: 011 378 8060
email:*********************.laimerThis document does not constitute an offer, or the solicitation of an offer for the sale or purchase of any investment or security. This is a commercial communication. If you are in any doubt about the contents of this document or
the investment to which this document relates you should consult a person who specialises in advising on the acquisition of such securities. While every care has been taken in preparing this document, no representation, warranty
or undertaking (express or implied) is given and no responsibility or liability is accepted by Standard Bank Group Limited, its subsidiaries, holding companies or affiliates as to the accuracy or completeness of the information
contained herein. All opinions and estimates contained in this report may be changed after publication at any time without notice. Members of Standard Bank Group Limited, their directors, officers and employees may have a long
or short position in currencies or securities mentioned in this report or related investments, and may add to, dispose of or effect transactions in such currencies, securities or investments for their own account and may perform or
seek to perform advisory or banking services in relation thereto. No liability is accepted whatsoever for any direct or consequential loss arising from the use of this document. This document is not intended for the use of private
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of it nor any statement herein may be taken or transmitted into the United States or distributed, directly or indirectly, in the United States or to any U.S. person except where those U.S. persons are, or are believed to be, qualified
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prohibited. Copyright 2004 Standard Bank Group. All rights ised financial services and registered credit provider (NCRCP15)
The Standard Bank of South Africa Limited (Reg. No. 1962/000738/06). SBSA 803129-I 03/09
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