Role of Currency Options in International Trade - Essay Example

? Currency Options and Their Role in International Trade Number: Due Introduction Any business enterprise can benefit greatly through proper management of their risk. Due to the increased competition in the international market, the need to plan and realize an effective business strategy that aims at coming with efficient risk management criterion is vital. The risk management strategies support price stabilization, the optimization of production capacities, the increase in market transparency, and increased security of distribution quality. In addition, the understanding of the ever changing current market is important as the trader gets to know of the fluctuating market prices of a commodity brought about by changes in currency. In order to deal with the problem of changing market prices, the trader needs to continually evaluate and analyze the functions of the market and the goals of the business enterprise (Stanley 1998). In addition, the business must be in a position to put in place new market rules and to be monitoring the trade trends and its development. In most of the world states, trade has emerged as one of the key sectors of the economy and most of her citizens depend on the trade for their source of living. The growth of the energy markets and the strategies of the energy providers have been the driving force of these trade improvements over the recent years. A number of commodities in the energy sector such as power, gas, carbon dioxide and even the weather have found their way into the trade market in societies. This has led to the improvement of the use of the scarce resources and increased complex organizations, process interfaces and the system infrastructures. The increased demand for data quality has led to most organizations to adopt the need for risk management that reduces the operational costs during the production process and the actual trading exercise (Dell’Ariccia & Marquez 2010). The international trade is finding its way in society and people have actively been involved in the same and this has led to the emergence of new market models such as market coupling are being discussed and this has made it easier for cross-border trading. On the other hand, the international trade implies that different rules and procedures must be followed and this has led to a change in the trading system that bring on board a number of challenges that require adaptation into existing risk management mechanisms. Exchange Traded Currency Options Foreign exchange traded currency options give a company or an individual the right to exchange the currency of their country into another currency of another country at pre-agreed exchange rate at a given time in the future. This is the world’s market option although most of the currency trade is done in private and hence it is not possible to determine exactly how large the market is. This form of trade is regulated however in a minimized way and most of the transactions are over the counter. With a few exceptions that are traded on exchanges such as the International Securities Exchange, the Philadelphia Stock Exchange, or the Chicago Mercantile Exchange that has options for future contracts (Dong-Hyun & Gao 2003). In the past, the universally accepted currency option was valued by the Bank for International Settlements. For any business enterprise that wish to grow in the international market, there is the need to value the Foreign Exchange factor. Most of the organizations often do not take this risk factor into consideration during their contracts hence the delayed growth, and success in the international market. The international market often fluctuates in value and a given asset or commodity valued at a given price at a present time might be valued at a higher or lower price in the future due to the exchange rate factor (Manzur, Hoque, & Poitras 2010). In the currency option therefore, the product that is to be traded called a derivative is based on a universally acceptable instrument that is often referred to as a foreign exchange. Hedging using options According to Foreign Exchange Management (1993), hedging options is the process of managing a risk in trade to an extent that it can nolonger have a great impact. Foreign exchange plays a vital role in international trade since the fluctuations in the foreign exchange currency can have a diverse effect on the decisions made by portfolio managers, fund managers and corporate treasures and most often determines the outcomes of the business transactions in terms of making profits or not. Most of the international trade dealings have become more risky and unworthy due to the exchange rate risk that is usually unpredictable. In the currency option system, the buyer of option enjoys some benefits of having the right to buy but not the obligation while the seller of the option on the other hand has the obligation in the trading of the given commodity that the buyer exercises their right. In the international trade, there are two types of options: Call options and the put options. The call options allow the buyer to exercise their right to buy a given commodity or a specified currency at a given exchange rate at or before the expiry of the specified date (Caracota-Dimitriu & Tabara 2009). However, in the put option, the buyer has the right to sell the commodity or the specified currency at a specified exchange rate at or before the expiry of the specified date. The seller of the option however, need compensation for giving that right to the buyer. This compensation is often referred to as the price or the premium of the option. Calls are thus used if the risk is expected in case the value of the asset increases and put options are used when the risk is the decline of the value of the asset. In the past, there was the use of forward contracts that often fixed the exchange rate between the two parties involved in the transactions for any future transactions between them. This easily eliminated the exchange rate risk but however it was difficult finding a person or party that would agree to fix the rate at a given amount and time period. Some banks however still provide the forward rate agreement as a service to her customers. This implies that by a customer entering into a forward agreement with the bank, they are able to transfer any risk that would be caused by the fluctuating exchange rate to the bank that has to bear the risk instead (Eltreheim, Froyland, & Roisland 1999). However, the banks itself do some activities that are aimed at managing the risk than an individual would do. The existence of shortcomings in the forward contracts led to the emergence of the present markets that made use of the exchange rate mechanisms to manage risks. The present contracts in the market are exchanged in an organized exchange rate hence the term liquidity. The currency options have made most transactions to be legal between the parties involved but however the obligation point is not mandatory. This implies that one party can make the reverse of the transaction before the expiry of the contract. Hedging process that has come into being in order to manage futures implies that in case a financial asset or traded commodity is expected to appreciate in value terms in the near future then one needs to buy futures and if the risk in the future is the depreciation in value of the asset then one needs to sell futures. The present international market that deals with the currency option to manage risks can be characterized by a number of standard features that are aimed at increasing the liquidity in the market. Traders are faced with a number of different conditions that need different actions too in the market. For example the need to trade at different rates in the future than at present presents a diverse condition that need a divorce action (Fisher & Kumar 2010). By having some standard measure to match the size of a contract with the future amount is often important. Some of the standardized features include: The expiry date, the contract time, the size of a contract, the number of contracts a party can either buy or sell at the given time, and the limit of the price. This shows how important the currency options are in solving some of the above issues while trading. Moreover, the currency options allow future contracts to be traded on a standardized and central market that play a part in increasing liquidity. Since there are many people in the international market, who want to make a profit at the given time, then one can be able to easily buy or sell. This solves the problem of double coincidence of wants that would exist in case the fixed exchange value rate options never existed. This problem was experienced in the past where the market was trading on future contracts only (Guo 2010). Trading using leverage has been discovered to have more benefits to the traders. Leverage is trading on credit whereby a firm or an investor deposits a small sum of money that would have high returns in the future. This is only possible through the margin system that is only possible in the currency option. Options are moreover, used as a hedging tool in the event of contingent cash flows for example during the bidding process. Take an example of a firm that bids for a project in overseas countries, the project that involves foreign exchange risk might need the company to quote the bidding price and consequently buy the put options to protect herself from the exchange rate risk. In case the bid is successful, and the exchange rate had depreciated the firm would be in safe hands since it had bought the put options. On the other hand if the bidding was not successful and the currency appreciated the firm would just let the contract to expire (Fisher & Kumar 2010). This implies that the firm would lose only the premium paid that is the only loss with options. If the bid was unsuccessful followed by a decrease in the currency, then the firm would exercise her right and make a profit from these conditions. Case Study of the U.S Dollar in 1995 According to research the dollar’s drop was as a result of the currency option called knockout option. Although the knockout option contributed greatly to the fall on the value of the dollar, their impact was great in the option markets. The dollar fell greatly as compared to the German mark and the Japanese yen and against several other currencies. This was the first time sine the dollar depreciated since the European monetary crisis and different explanations have been put forward to explain the cause. Some research claims it to be due to the macroeconomic factors in the currency markets but however the influence of the currency options played a big role in the poor performance of the dollar during this period (Chang & Pong 2003). The market research has pointed out that knockout option is in particular to be analyzed critically in order to understand its role in the poor performance of the dollar at that period. The knockout option that impacted greatly the option markets and the hedging reactions that were made as a result of the decline in the dollar also played a role. In this case study the role played by the knockout option is discussed in detail. The Knockout Option Market The knockout Options differ from the normal currency options in such a way that in case the exchange rate reaches a certain level they would be cancelled. Knock-out options are common in Europe and most dealers and nonfinancial corporation deals with knockout options. The customers usually use the dollar against the yen and the German mark to buy these options. Other European currencies are also involved in the exchange rate. By using the the knockouts, buyers usually expose themselves to the risk of getting losses that arise from their cancellation. For example, the U.S exporters might buy dollar calls to act as a form of protection against a stronger dollar in future but would be at a risk of losing the if the knockouts are cancelled (Libo & Liyan 2011). In the contrary, if the dollar lost her value and regained rapidly to higher levels, the options would also be cancelled and the exporters would be at a loss in case of the scenario (Dong-Hyun & Gao 2003). Japanese customers were also at a risk of losses if they bought the dollar and its exchange rate dropped. Customers were therefore buying options to hedge against the adverse exchange rate of the dollar but why were dealers hedging options? These would be of great help to assist understanding the events that led to the drop of the dollar value. Hedging Knockout Options Dealers at that time held inventories that were an indication of the standard of those options bought and sold and the knockout options on the currencies that were to be protected against the losses that came into being as a result of the changes in exchange rates, option prices, interest rates, and once the options matured. The standard options were at most of the time hedged by dealers through buying and selling them depending on the exchange rates. In an example, it would be seen that dealers that were selling dollars put were also forced to hedge the puts against any losses if the dollar depreciated or the puts had to expire. This implied that they would be in a position to sell the at a favorable exchange rate than what they were sold at by the option holders (Chang & Pong 2003). In the same way dealers were also forced to protect their knockout options against losses that would arise as a result of market changes in the prices of the options and their maturities. But it is to their disadvantage that these options especially the puts were difficult to hedge. These forced most dealers to manage their risks through the combination of the standard of those bought and those that were sold in relation to the currency options. This is aimed at curbing the changes in the value of the options arising from changes in market prices. Dealers have thus different strategies on how to hedge the knockout options, by a combination of the buying and selling standard options as the prices change and the maturity of the puts come nearer (Eitrheim, Froyland, & Roisland 1999). Moreover, the dealers also take into consideration risks that arise out of other options in the inventories. Some of the hedging strategies of the dealers include: Selling large amounts of universal puts, taking into consideration the subordinate role of hedging, having a less frequent hedge adjustment and protection of the puts within a given range of the exchange rates. These strategies made it possible to hedge calls than the puts. This implied that dealers would hedge a sold option call by buying dollars initially and selling them if the exchange rates fall rather than hedging them with options (Stanley 1998). However, the issue that knockouts were cancelled if the exchange rate touches the outstrike level meant that dealers would attach stop-loss orders so that they would sell the dollar once it reached the outstrike level. This practice forced the dealers at most of the time to buy large amounts of standard options at the same time the same way other market participants did to contain the effect of the cancelled knockout options. Thus customers too sold dollars when the cancellation of the knockout options left them with no option than to look for protection of the losses against the weaker dollar. This event added to a lot of selling of the dollar since there were the selling of the dollar in the market not as a result of protection but the normal market business (Fisher & Kumar 2010). Conclusion The fall of the value of the dollar is believed to have been brought about by the impact of the options on the exchange rate. These options to sell the dollar in order to get protected against the risk of losing the options only added pressure on the dollar that was already being sold for business purposes. From above, it is however clear that the option calls played an insignificant role in the fall of the dollar. The option puts had a great impact on the option prices. The cancellation of the knockout options once they reached the upstroke level led to the large demand of the standard put options in the option market by former holders of the cancelled puts and more so the dealers who had sold them (Guo 2000). References Caracota-Dimitriu, M, & Tabara, O. (2009), 'The Importance of Market Risk Measurement of Traded Instruments in the Banking Risk Management', Economic Computation & Economic Cybernetics Studies & Research, 43, 1, pp. 165-182, Business Source Complete, EBSCOhost, viewed 20 March 2012. Chang, E, & Pong, W. (2003), 'Cross-Hedging with Currency Options and Futures', Journal Of Financial & Quantitative Analysis, 38, 3, pp. 555-574, Business Source Complete, EBSCOhost, viewed 20 March 2012. Dell'ariccia, G., & Marquez, R. (2010), 'Risk and the Corporate Structure of Banks', Journal Of Finance, 65, 3, pp. 1075-1096, Business Source Complete, EBSCOhost, viewed 20 March 2012. Dong-Hyun, A. & Gao, B. 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