Risk management

Exchange Traded Currency Options

International Risk Management

Vanish Patel - 11165622

WORD COUNT: 2613 (excluding executive summary, appendix and references)

Vanish Patel International Risk Management Ben Nowman11165622 4FIN7A5 Stefan Van Dellen

Executive Summary

The literature review on risk management and derivatives found three core risks that needed to be

hedged against: transaction; translation and economic. Transaction refers to the risk of cash flows

and monetary valuations, translation is mainly an accounting concept that referred to the concepts

needed to consolidate the foreign accounts to the domestic accounts and the economic risks were

focused on the general risks created for operating in another economy, such as political and default.

The review also found the forward contracts are highly favoured over all other forms of derivatives

because it reduces uncertainty.

The body outlines the details of options and the pricing model used. The two main types of options

are call and put options, which allows the investor the right to buy and sell, respectively, the

underlying asset at the specified price on a specified date of expiration. The Garman and Kohlhagen

pricing model is an adaptation of the Black-Scholes-Merton model for options, where the change is

made to accommodate for a currency and the interest rates of the domestic and foreign market.

There are many assumptions for the model such as normal distribution, no arbitrage, no transaction

costs incurred, constant interest rates, geometric Brownian motion of no jumps in the market and

full liquidity in the market. The payoffs of the call and put options are explained, for both the long

and short positions, and show the out of the money, at the money and in the money areas of the

payoff. The figures also show how the premium of an option will decrease as the expiration nears as

there is a lesser likelihood of it being exercised.

The report concludes in saying the exchange traded options are very important for hedging, and that

the investor can hold many options to ensure they make a profit at exercise. However, investors are

seen to choose forward contracts as a primary method of hedging because it reduces the overall

uncertainty for the company.

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Table of Contents

Executive Summary...............................................................................................................................1

Introduction...........................................................................................................................................3

Literature review...................................................................................................................................4

Details of contracts................................................................................................................................6

Conclusion...........................................................................................................................................10

Appendix.............................................................................................................................................11

Figure 1 – Short call.........................................................................................................................11

Figure 2 – Long call..........................................................................................................................11

Figure 3 – Short put.........................................................................................................................12

Figure 4 – Long put..........................................................................................................................12

Figure 5 – Call payoff.......................................................................................................................13

Figure 6 – Put payoff........................................................................................................................13

Figure 7 – Long put and long call payoff..........................................................................................14

Figure 8 – Changes in premium due to change in maturity date.....................................................14

References...........................................................................................................................................15

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Introduction

Risk management is the process by which companies and banking institutions limit the exposure of

risk via derivatives, whether they are security derivatives or bond derivatives. These derivatives

ensure that if a company’s investment takes a negative turn, the derivative in place will ensure that

there is no loss (Madura, 2010). A company can limit their risks on a one to one basis known as risk

decomposition, or it can group the risks together and find a derivative that combats the grouped risk

which is known as risk aggregation. Risk is also limited if the corporation has diversified its portfolio

into many different industries to reduce unsystematic risk and by investing in different economies

which reduces systematic risk.

A method of reducing risk in the banking sector is by increasing the number of customers that the

bank loans out to. This allows the bank to spread risk to many customers with lower default chances

as opposed to one large loan to one customer who has a higher chance to default (Hull, 2010). Many

investment institutions will aim to reduce risks they are exposed to, with the intention to keep

returns secured for investors.

There are many different types of risks that affect the business model of any type of corporation.

Examples include strategy risks, transaction risk, translation risk, economic risk, currency risk, default

risk and unknown risks such as natural disasters. Each of these risks have different weightings and

differ between the sizes of companies and the industries they operate in, where the risk change due

to geographical location, government legislation and corporate governance (Pilbeam, 2006).

The common methods of hedging by corporations are forward contracts, futures contracts and

option contracts, and this report will focus on the latter for the literature review and the body which

will provide details of various option contracts. A conclusion will be ascertained based on the

findings to see if options are the best way for hedging.

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Literature reviewRisk management is considered to be a very important factor for many businesses, in the global

environment (Marshall, 2000), and is seen to be the most important factor in relation to all risks that

a business can encounter. Due to globalisation, companies have now expanded operations to other

countries and are now to open to foreign exchange risk. The problems that companies have found is

that transactions need to be protect against the adverse effects of foreign exchange rate changes

and volatilities in currencies (Marshall, 2000). The one problem with this research paper was that

they had sent a total of 600 surveys, but only received 179 useable responses, which shows a very

low response rate that may not factor in all the industries they intended to. There are other risks

that multinational corporations experience, which are translation and economic, as well as the

transaction risk mentioned before. Translation risk is an accounting standard risk which changes the

figures of a parent once the accounts are consolidated, while economic risk refers to the risks

created by operating in another economy (Pilbeam, 2006).

Companies can use different methods to hedge against adverse movements in assets and liabilities,

either via internal processes such as netting, leading and lagging, and external methods like futures,

forwards and options. Forwards seem to be the most important method of hedging and risk

management because companies can create specialised contracts, with a specified rate, for a

specified time horizon and a specific amount of money. This reduces a large amount of uncertainty a

company faces as they can lock in aspects in a forward contract, which would normally be variable if

no contract is made (Wells Fargo, 2011).

Investment institutions, and to some extent hedge funds, have a massive focus towards the changes

in foreign exchange as their portfolios maybe in many different countries, or even if they are not in

different countries, the companies they invest in are most likely to operate globally. The use of

options are the best method of hedging as they can be beneficial if the underlying asset decreases,

with the protection of a put option, and if the underlying asset increases in value, with the

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protection of a call option (Topalogou, 2011). Investors will uses options to improve the long term

return of their portfolios and tend to use 2 options to create a “Quanto Option” which consists of

one option to cover cash flows from the investment in the stock index and another option that is

used to cover the changes in the currency. This author however had only used a one month time

interval to get its results for the options because options are often considered to be short term. The

author did however use monthly observations for 15 years over 4 indices in 3 currencies to get a

wider range and unbiased sample.

In some industries, currency risk is not seen to be the most important factor for risk management.

Financial risk is seen to be very important in the real estate market due to investors needing to

create high levels of debt in order to make most real estate purchases via a mortgage where the

basic financial risk of not being able to make repayments on the mortgage. Options are therefore not

very good for long term investments as they are costly so other methods like forward contracts are

used (Ziobrowski, (1995). The author concluded that for real estate, if investment is needed to be

made in another country, then a forward contract would be the best derivative. However, they

made further comment in saying that due to the long term outlook, making an equally costly

investment in the domestic market with a mortgage is better because there is no currency risk to

account for. Also, they noted that in the end, the real estate investment create little or no return as

keeping a long term hedge was costly in fees and premiums.

As mentioned before, there are three types of risks that businesses are exposed to: transaction,

translation and economic. There is a large emphasis on transaction and economic risk, but not so

much on translation. The reason for this would be that translation is an internal accounting control

and UK firms seem to prefer external methods of hedging (Joseph, 2000). The article splits the

sample into hedgers and non-hedgers, and finds that companies prefer to use forward contracts

much like the rest of the literature. If cash flows of a company are constant, a forward contract is a

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better derivative, because an option is based highly on making profits on the volatile nature of the

financial markets.

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Details of contracts

This part of the report looks at the details of option contracts, a payoff diagram of options, the

pricing method used and features of exchange traded options.

An option contract allows the “investor the right to buy (or to sell) something – anything from a

share to a barrel of oil – at an agreed price and at an agreed time in the future” (BBC, 2012). A call

option refers to a holder’s right to buy, while a put option relates to the holder’s right to sell, where

both have the right but not the obligation. Within these options, they can be based on shares or

currencies, and this report will be focusing on exchange traded currency options.

Normally an option will have an underlying asset of a share price, but in a currency option the

underlying asset is a specified currency exchange rate. There are two currency quotes used, one

being the strike price which is specified in the option contract, while the other is the current spot

price which changes according to the live trades in the financial markets. A call option allows the

holder of the option to buy the currency at the strike price stated on the option. If the strike price is

less than the spot price, the call holder has the right to buy the currency at the strike price and sell at

the spot price. This is known as being in the money. The holder is able to make profit after they have

paid a premium, and the holder is expecting the domestic currency to appreciate and the foreign

currency to depreciate. An example would be where the strike price is €1:$1.3 but the spot price is

€1:$1.5, so the holder will make $0.2 per total nominal value in the contract. A put option is the

opposite of a call option, whereby the holder expected the underlying asset to decrease in value. In

the example above, if the exchange rate were to become €1:$1.1, the holder can sell at $1.3 and

buyback from the market spot rate of $1.1 (Financial Times, 2011).

Investors can choose different maturities for their options when the contracts are created, however

the standardised ones will be set in 45 days, 90 days or 180 days etc. There are different positions

for the options: short call; long call; short put and long put, as shown in figures 1 to 4 respectively. A

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short call is shown in the view of the issuer of the call option, where the issuer makes a profit from

any point until the strike price, where the profit is the premium fee. They are the short position

because they are in the position of selling the asset, while the long call holder is in the position to

purchase that asset, as shown in figure 2, and both are the opposite of the other. The put option is

the opposite of the call option in relation to their payoff diagrams. In this case, the short position of

the issuer makes a loss in the short position, but the holder makes a profit in the long position (Hull,

2008).

The equation below shows how the premium is calculated using the Garman Kohlhagen model.

C= Call Option So= Spot Price rf= risk free in domestic market T= TimeP= Put Option K= Strike Price rd= risk free in foreign market σ= VolatilityLn= Logarithm e= Exponential

Figure 5 shows a call option where the investor will make money after the spot price has gone

beyond the blue vertical line which is the strike price, this is known as in the money. The out of the

money area is constant because that is a cost of the premium, however as the spot price increases

towards the strike, the option changes from out of the money to at the money, where the spot and

strike are exactly the same, then in the money. The option can still be in the money and making a

loss because the investor is covering the cost of their premium. When the spot price meets the

horizontal axis, the spot price is the strike price plus the premium cost in the denominated currency.

Figure 6 shows the same definitions on a put option, and both figure 5 and 6 are in the long position.

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N(D1) is the rate of change in the premium and is the cumulative probability of it occurring. It is

denoted between 0 and 1, where 0 is zero probability and 1 is full probability. N (D2) is the

probability of the option being exercised, and is also denoted in the same way as N (D1). The greater

the chance of the option being exercised, the larger the N(D1) and N(D2) values will be as they will

incorporate greater intrinsic value and time value (Pilbeam, 2006). The “N” refers to the

corresponding value on the normal distribution table, which is required to meet the assumption of

the normal distribution assumption of the pricing model.

Delta looks at the derivative of the change in the value of the nominal value over the change in the

value of the underlying currency. As the underlying asset price increases from the strike, the delta

will grow at an exponential rate until it reaches 1. Gamma is the derivative of delta, which looks at

the change in delta over the change in the underlying asset. If the gamma is small, the shifts in delta

changes slowly. When the strike is closest to the spot price, the gamma is at its largest point;

however a small gamma means that the delta notation is almost neutral. Both delta and gamma

neutrality cannot be achieved because of the changing values of the underlying assets, and therefore

continuous hedging needs to be done (Hull, 2010).

There are two main types of options that are created known as vanilla options, which can be either

European or American options. A European option only allows the holder to exercise at expiration,

whereas the American option allows the holder to exercise at any time between creation and

expiration. Option premiums are calculated using the Garman and Kohlhagen (GK) currency pricing

model, which is based on the Black-Scholes-Merton share pricing model, however the GK model has

many assumptions. Firstly, the interest rates of both domestic and foreign markets are constant and

never change, and considering options are usually for a short period of time, this in reality tends to

be true. However, during the subprime crisis, interest rates of many countries had been cut

drastically to ensure that the economy spends, this had caused problems to premium pricing. This

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leads to the assumption that there are no drastic jumps in the market, which is the Geometric

Brownian Motion assumption, where there is constant volatility. Other assumptions include: no

transactions costs but banks and financial institutions charge fees or margins to make their own

profits; that the markets are fully liquid but some currencies are illiquid due to political problems or

hyperinflation; the markets are in constant trading but in reality markets close at weekends; and

finally that there are no arbitrage positions available in the market. Furthermore, the GK model, and

the Black-Scholes-Merton model, is only able to calculate premiums of European options. The reason

for this is that the American option, which can be exercised at any time, does not have a specific

time period (Chriss, 1997). The GK model also assumes log normal distribution and follows a normal

bell shaped distribution. This is another problem to the model as in reality, the market has skewness

and kurtosis, and therefore the distribution changes shape from the normal bell shape (Hull, 2012).

Options can be created in two variations. The variation is the standardised currency option, whereby

the option has a standard nominal value, for example the PHLX World Currency Options (WCO) has a

standard nominal value of 10000 in the denomination of the underlying currency (NASDAQ OMX,

2012). The other variation is the Over the Counter (OTC) method whereby the option is created to

the specific needs of the customer. The OTC option is usually created by a bank and the customer is

able to set the strike price, the expiry date and what type of option it is (Redhead, 1990). The

exchange traded option is standardised to ensure that it can be traded on the secondary market if

the holder wishes to sell the option onto another investor that will have been use of it and the

option will be liquid to the market if the underlying currency is liquid. One benefit of having a

standardised contract is that the option writer has low default risk and counterparties do not require

collateral when holding an option (Hull, 2012).

The Philadelphia Stock Exchange is one of the largest exchanges in the world that specialises in

exchange traded currency options, and they have a variety of contract options for customers to

create. Another exchange is the Chicago Mercantile Exchange (CME) Group.

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Conclusion

It is important for companies to use hedging via derivatives to ensure their value of inflows are

known to ensure the company meets domestic markets’ expectations. If no hedging is undertaken,

the company will be subject to the great volatilities that surround the global financial markets, which

can erode foreign profits or even make a realised profit in another country into a loss in the

domestic currency due to currency risk. Exchange trade options are one of the best methods of

hedging as it allows the investor to sell the option if they no long require it, and there is usually a

buyer for the option on the exchanges. Even with this great flexibility of being able to sell the option,

companies still choose to use forward contracts. The literature review found the usage of forward

contracts has increased and this could be because of the sub-prime crisis and more recently the Euro

Debt crisis. This shows that investors are now taking a less risky position on the market by forward

contracts to reduce the uncertainty risk of unknown situations.

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Appendix

Figure 1 – Short call

Figure 2 – Long call

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Figure 3 – Short put

Figure 4 – Long put

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Figure 5 – Call payoff

Figure 6 – Put payoff

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OUT OF THE MONEY

IN THE MONEY

AT THE MONEY

IN THE MONEY

OUT OF THE MONEY

AT THE MONEY


Figure 7 – Long put and long call payoff

Figure 8 – Changes in premium due to change in maturity date

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References

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Economy & Finance

Risk management