TREASURY CLASSROOM VOLUME 93
Atul Gupta
Corporate Treasury PWC AC| Six Sigma, Currency Derivatives| Ex- Deloitte|Ex- KPMG
OPTIONS VS FORWARDS CONTRACTS
Forward Contract- Locking a rate over a period of time. It is a obligation that you have to exercise the contract. And it is not traded on exchange. For example there is an exporter who is in India he is exporting textiles to United States.whose denominated currency is in dollar. As now the major risk that an exporter faces is the Currency risk. And on 1st jan 2019 he had shipped the goods and expected to receive the payments after 180 days. And now he faces a currency risk for 6 months. As to mitigate the currency risk he enters into the forward contract with the bank at an agreed date to deliver the dollar and take the INR. Suppose on booking date let suppose INR was st 60 (Spot Rate). And if he books on 1st Jan 2019 till 30th June 2019. Than Suppose premium for one year is 3 rs . Now for 6 months he will get a premium of Rs 1.5. So his outright rate will be locked at around 61.50. Now irrespective of the rate goes anywhere he is hedged at 61.50. But suppose currency depreciates from here than he cannot participate in the upward movement.
Options Contract- In this the exporter and importer is having the right to exercise the options according to the strike prices. But they do not have the obligation unlike the forward contracts. Now to select the strike price. It totally depends on the moneyness of the option.
Moneyness of the options can be divided into three parts
- At The Money
- In the Money
- Out of Money
And as Corporate treasurer are reluctant to take the options due to the hefty premiums they need to shed out. But the Beauty of the moneyness is that you can select that how much amount of premium you need to shed out. Let us Understand with the Example
And also right now in this article I am taking Examples of Plain Vanilla Options Contracts. As for the importer it is beneficial to buy call option. And for the exporter it is beneficial to buy put options.
Let suppose there is an Exporter who enters into the Put options contract. of USD/INR
Let suppose transaction amount is $10 million. As now in case of Buy Put the Exporter is having right to sell to the bank at an agreed rate.
Spot Price- 70
Implied Volatility- 10% (for 6 months)
In The Money- 77
Deep in the money- 84.7
Out of the Money- 63
Deep out of the money- 56.70
Below is the calculation of Strike Prices-
In the Money- 70+ 1 Vol= 70+ 10%= 77
Deep In the Money- 77+1 Vol= 77+10%= 84.7
Out of the Money- 70-1 Vol= 70-10%- 63
Deep Out of the Money- 63-1 Vol= 63-10%= 56.70
Implied Volatility shows that how volatile will be the currency markets in future.
If we enters into the In the money options than we have to shell out hefty premium. As Market is allowing you to pay 70 but you want 74 so you need to pay the hefty premium. But in case of the Out of the money you will pay less premium as market is trading at 70. Market is allowing you to pay 70 but you want 65.
Now it is advisable to take out of the money contract. And also take 1 implied vol away. As you can take 0.5, 0.8 0.9 implied vol away. obliged to deliver. But in option you have the right.
As you can see in the option contract the only cost is is premium. And that too you can decide based upon the moneyness of the option. And now in case of the forward contract your rate is locked at 61.50. but suppose INR depreciates than he can participate in the upside movement in the market by protecting the downside.
Disclaimer- Only for Informative Purposes.
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