Use of Currency Options in Risk Management Companies - Essay Example

DISCUSS THE USE OF CURRENCY OPTIONS IN RISK MANAGEMENT COMPANIES CAN USE and of Submission Executive Summary Currency options are versatile tools that corporates can use to hedge their currency, as well as, giving investors humble opportunities. With the increased international trade and various risks that are associated with foreign exchange, companies find it challenging to withstand losses that result from fluctuating currency rates. The paper focused on how firms may use different hedging techniques through currency options to stand a better chance of not losing their equity. Additionally, the study aimed at investigating how currency options work and the various factors that affect their functionality and demand, as well as, how their value can be calculated. The study used article review as the methodology technique. The key findings entail; American, Plain Vanilla, OTC and the European options as the most convincing hedging techniques firm ought to use. However, they can be of two types call or put options that allow holders to speculate and decide on the best technique to adopt to avoid financial loss. Interest rates, risk-free rates, market volatility, striking price and maturity dates are the key influencing factors that determine the hedging techniques in these options. However, the value of the options can be determined via the Black-Scholes model that is recommended for its ease of use and effectiveness. The study recommends examining of other types of options such as the average rate and basket options including other currency hedging techniques for future research. Keywords: currency options, risk management, financial markets TABLE OF CONTENTS Executive Summary ………………………………………………………………...2 Introduction …………………………………………………………………………4 Definition of terms ………………………………………………………………….5 Purpose of study …………………………………………………………………….5 Types, Application and discussion …………………………………………………8 Plain Vanilla options and Interest rates differentials…………………………..8 American Options and market volatility……………………………………………9 European, OTC and Risk-free interest rates……………………………………….10 How can companies value currency options……………………………………….11 Conclusion ………………………………………………………………………....12 Reference List ……………………………………………………………………..13 Introduction Currency options are contracts that grant the holders the right to sell or buy currency a given exchange rate during a particular period. However, the holders do not have the obligations over the transactions. The right of the transaction entails a premium that is paid to the brokers, and it varies with the number of contracts that are purchased. Currency options are part of the hedging techniques that are used by corporates and individuals against adverse fluctuations in the exchange rates. For instance, investors tend to purchase a currency options call or put (Debora 2000). For example, if an investor anticipates that the rate to buy Euro currency using the dollar will increase from 0.86 to 0.91, it indicates that it will be more expensive. Consequently, the investor requires a call option on the dollar/Euro so as to stand to gain from any increase in the exchange rates. These options have gained acceptable invaluable techniques in the management of foreign exchange risks; used to bring a wider range of hedging options to their unique nature. Moreover, options are attractive financial instruments to financial portfolio corporate and manager’s treasuries (Debora 2000). Currency options have traded in the options markets and bear unique attributes unlike other hedging techniques such as the forwards and futures. The two basic options are call and put currency options. The call options give the holder the right to buy a specified amount of currency at a particular strike price but the seller of the call option has the obligation to buy the underlying contract if and only when the holder takes their right (Daniel 2014). Meanwhile, the put option offers the buyer the right to selling the underlying currency; however, in this case, the holder has the right to sell while the seller bears the obligation to buy the currency whereof the holder assumes the right. Consequently, this gives a two-way transaction; one currency is sold while another one is simultaneously bought. For instance, if a foreign transaction entails buying dollars against the Kenyan Shilling (USD call) is an option to sell Kenyan Shilling against the dollar (put option). It, therefore, indicates that in every foreign transaction, a currency is sold, and another is bought (Daniel 2014). Definition of options terms Holder – is the owner of a valid option contract. Premium – is the cost of the option that has to be paid while purchasing time that is up-front and it depends on a number of factors. Exercise – indicates calling upon the right granted under the terms of the option. Strike price or rate – is the rate at which the holder is entitled to sell or buy the underlying currency and is determined by the time of purchase. Expiry – is the final date in which the option has to be exercised regarding the terms of the contract. Purpose of the study Currency options are versatile tools that corporates can use to hedge their currency, as well as, giving investors humble opportunities. In every option market, these risk instruments bring added advantage of trading on a robust, secure and a transparent medium, which aids in efficient discovery of price. Therefore, the paper digs to examine various currency options in the foreign exchange markets and how they can be used by corporates. Literature review Currency options are an essential aspect of foreign trade that most scholars have investigated on their basic functionality and usage. Most literature sources have dealt with explaining different types of currency options and how they can be used by corporates in their risk management practices. Baldwin & Richardson (1986) highlight the immediate reason as to why corporates trade in currency options. Accordingly, the scholars argue that corporates have been increasingly using options to reduce currency risk. The scholars claim that the volatility smile is the key reason corporates and individuals hedge in currency options. Additionally, they claim that the options are inexpensive techniques to gain access to currency investment without purchasing any stock. Through such a technique corporates can enhance their currency portfolio, as well as, returns. Foreign trade is faced by floating exchange rates which may fluctuate unexpectedly, thereby, reducing this risk to avoid financial loss corporates engage in currency options (Baldwin & Richardson 1986). Volatility of exchange rates affects cash flows of an organization if it is involved in foreign trade. Therefore, this gives rise to the transaction exposure while the firm may be concerned with its future value of its operating cash flows. In such a case, the firm is motivated by economic exposure to hedge in the currency options to stand on the safer side as rates may fluctuate leading to a loss (Coyle 2000). Additionally, there are other risks that an organization may stand to take that may affect their future value of their stock. They include call, liquidity, inflation, credit and interest rate risks. All these pose a threat to the loss of value of currency trading calling out for corporates to hedge. Daniel (2014) argues that these options create a wide range of payoffs; however, buyers ought to determine the market outlook, volatility, best strike price and the margin requirements for purchasing an option. There are different types of currency options that have distinct features and functionality to a company. Plain vanilla is the basic options contract that has only the strike price and the expiry date with no additional features. These are simple trading options thus making most corporates hedging in them. However, due to convenience and business emergencies corporates consider using the American options that may be exercised anytime during their life indicating that there is no restriction to its maturity dates. These are different from the European types of options which ought to be exercised only at maturity dates. Other types of options include over-the-counter, and the exchange traded options. OTC options are traded off-exchange and not listed in the stock options and offer a direct link between the seller and its buyer. It, therefore, indicates that they have neither standardized striking prices nor expiry dates (Debora 2000). Consequently, the exchange-traded currency options allow standardized terms by the exchange indicating that its expiry date, quantity, and striking price are known prior to execution. The usage of these options is determined by the goals of the firm, as well as, financial status and speculated interest and exchange rates in the foreign markets. Most scholars have examined the different factors that affect the striking price and the valuation of an option. For instance, Allan (1995) examines the value of the dollar during the economic crisis of 1992 and claims that part of this crisis was brought by the influence of the currency options. Corporates focused on the knockout options that resulted from low-valued dollar during this time. In his research, the exchange rates play a big role in influencing their striking price. Additionally, Allan (1995) observes that the underlying option prices, prevailing interest rates and the maturity dates of the options are the key determinants. However, these factors make these options hard to hedge as buyers may stand to lose with economic deterioration. Therefore, they become less demanded, raising the explanation to what happened in 1992 in US economy, as these options had much pressure on the dollar. Lastly, researchers have appreciated the use of the Black and Scholes model in the valuation of the options. Most scholars have extended this model and assumed relaxation of its assumptions. In their methodology, Bigger and Hull (1983) uses the value of European call and put options on foreign trade under various assumptions; price of a single unit of foreign currency shows a Brownian motion, no transaction costs in foreign trade, risk- free interest rates, non-dividends on stock. The scholars argue that it is possible in creating riskless hedge using European call options and the stock used to write the contract. More conveniently, Bigger and Hull (1983) finds that using the Black –Scholes formula, forward rates, and spot market prices played the central part in the valuation and influence on the currency options. However, the sources that were reviewed, none addressed how the currency options can be applied in the corporate environment in developing their risk management strategies, as well as, their limitations (Graham 2014). The study, therefore, identified the commonly used option contracts and focused on their applicability and drew a few of their limitations to formulation of international risk management plans. Types, application and discussion Plain Vanilla options and interest rate differentials For corporates trading at international level are faced with various risks that results from the volatility of exchange rates. International equity investments have built momentum with the increasing risks and the equity traded-funds (ETFs). Plain vanilla is the basic hedging technique that firms can use to hedge their selves against these market risks. Consequently, this is the pure and local equity return in the foreign market that has no secondary features attached to it. Therefore, these are the automatic default options for foreign equity exposure that firms may consider investing in them. Companies need to consider the different trade-offs of hedging in the plain vanilla options. Interest rate differentials from both the markets of seller and buyer are a key factor that companies should consider before hedging. For instance, investors from high-interest rates than US, the cost of hedging may be high. For example, if a company using Yen anticipates that interest rates in US will increase before they do in Japan, it may consider investing in hedging to earn high returns (Walmsley 2000). American options and market volatility Companies that have no speculation techniques for the foreign markets can consider hedging in the American options. These options allow the holders to exercise them anytime during their life prior to its maturity date, maturity date included thus they tend to increase the value of the option of seller unlike any other options. Consequently, profit maximizing firms have to consider hedging in these options. For instance, if company ABC buys a Ford call option in March 2015 and expiry date is March 2016, the firm can exercise the option any time until maturity. However, the company has to speculate and exercise the option when its share price is most optimal, otherwise it would be virtually worthless when its out-of-money. Volatility of rates in the market is a key determinant that Company ABC has to consider. Implied volatility is the ideal culprit on the option price behaviour. Firms ought to understand the market volatility to cushion their selves against any possible losses. Consequently, it can add a substantial bonus to trades that are winning to the holders. According to Graham (2014), there is an inverse relationship between option prices and volatility. Moreover, both the options demand and prices may experience a positive volatility effect from changes in the foreign markets, and this can be achieved with short put American options that place a better stand of winning the best returns for firms (Graham 2014). European, over the counter (OTC) options and risk-free interest rates The European options can only be executed during their maturity dates and they allow traders trade them at a discount as compared to other options. These are examples of over the counter options and therefore, they are not standardized. Apart from volatility and interest rate differentials there other factors that affect the pricing value of the European options. The striking price is an underlying factor in which companies ought to consider (Wunnick, Wilson & Wunnickie 1992). OTC options on the other hand are exotic options traded over the counter markets where participants have the freedom to choose what options to trade depending on the prevailing market conditions. Firms prefer these options to European and the plain vanilla options since they do not have restrictions of the standardized options. Cost effective firms ought to consider these options as they are flexible and can allow them achieve their desired financial positions (Wunnick, Wilson & Wunnick 1992). In addition, the expiry dates is a key determinant to the firms that considers in participating in EPO trade. Consequently, these factors lead to various risk takers for the European and the OTC options namely, hedgers, arbitrageurs and speculators. All these stand to gain from these types of options. Firms can choose to hedge with the Put options or speculate with the call options. For instance, if Company XYZ has $ 1 million shares (currently selling at $10) in AAA firm and it is worried that the share price might decline the following month, XYZ can consider buying put options with exercise price of $10 that expires the following month (Capinski & Kopp 2013). Consequently, this is hedging against the risk of fluctuating rates; therefore XYZ does not have to sell the shares now. Meanwhile Speculators approach the market in an optimistic way. If XYZ speculates a gain over the next seven months, it may consider buying call options with $10 as the exercise price that expires within seven months. While the company may be faced by the arbitraging alternative to consider two or more markets where the firm can buy portfolio shares from a undervalued option market and exercise the contract from a higher valued option market through the OTC options. The three alternatives make the XYZ firm stand a better chance not losing its equity during any market shock. Increased interest rates increases the European call and the OTC options while on another hand, it reduces the European put prices. Risk-free interest rates are a determinant to hedging in the EPO and the OTC options (Capinski & Kopp 2013). How can companies value currency options? Valuation of all options is a stochastic event that depends on various factors as they prevail in the market. Being a risky activity there are advanced strategies that help reducing and managing these risks. Most scholars have adopted the Black-Scholes model for pricing and evaluating different options while other scholars have extended the model to integrate more complex market components (Capinski & Kopp 2013).. However, companies may adopt the use of the basic BS model to evaluate the price the options they are trading. The model assumes lognormal distribution of stock, volatility and log returns are known and constant during time of valuation, continuous trading, perfect capital markets, zero transactions cost, and no arbitraging opportunities. In addition, the variables on the BS model are constant except t. the key components include current asset price; So, strike price; K, Expiry time; T and risk-free rates; r while the volatility may be given as . Call and put options are affected differently by these variables. For instance, they show either direct positive or inverse relation to these variables as shown (Capiński & Kopp 2013) In evaluating the prices of the put options (Pt), firms may adopt this formula from BS model where; and Meanwhile the price for call options may be determined through the BS model given as where; and Conclusion In conclusion, currency options help companies in hedging against market losses resulting from fluctuating interest rates. They act as buffers to financial losses. They are risk management techniques that firms have to consider. Plain vanilla, American, European and the OTC options are the basic options that firms operating in a foreign trade may hedge its stock. Market volatility, risk-free interest rates, the expected strike prices and the maturity dates influence the demand for all these options. The study reveals that American put options and the OTC options are most profitable in hedging them. The BS model has been appreciated for its efficiency in evaluating the price of options during hedging activities. The study recommends examining of other complex option-trading in foreign trade such as basket and average rates options. References List Allan M. M., 1995, “ Currency option markets and exchange rates: A case study of the US dollar in March 1995. Current Issues on Economics and Finance. Bigger N. & Hull J., 1983. The valuation of currency options. Associate Professors of Finance. York University, Canada. Baldwin, R. E., & Richardson, J. D. (1986). International trade and finance: readings. Boston, Little, Brown. Capiński, M., & Kopp, P. E. (2013). The Black-Scholes model. Cambridge, UK, Cambridge University Press. Coyle, B. (2000). Currency options. Chicago, Ill, Glenlake Pub. Co. Daniel A., 2014, “ Usage of Option contracts for foreign exchange risk management. Journal of Economic Studies. Florentina-Olivia Balu, Bucharest Derosa, D. F. (2000). Options on foreign exchange. New York, John Wiley. Graham, A. (2014). Currency Options. Hoboken, Taylor and Francis. http://public.eblib.com/choice/publicfullrecord.aspx?p=1619033. Wunnicke, D. B., Wilson, D. R., & Wunnicke, B. (1992). Corporate financial risk management: practical techniques of financial engineering. New York, Wiley. Walmsley, J. (2000). The foreign exchange and money markets guide. New York, Wiley. Read More