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October 18, 2017 at 10:31 pm
I understand the following happens on exercise date:
22x 31.250×1.475= $1.014.062,50
Since we only need $1M we convert the excess back to pounds at spot:
14.062,50/1,412= GBP 9.959
In the end we spent GBP 687.500 (22×31.250) – 9.959 = GBP 677.541
So this is the net cash outflow excluding the premium, am I right?
John Moffat says
October 19, 2017 at 8:19 am
September 2, 2017 at 12:25 pm
I’m unclear about why we’re claiming the difference between strike and spot when exercising the option.
August 30, 2017 at 6:14 pm
I was just wondering is there any way of remembering which way you are buying/selling when it comes to supplier payments?
I understand that if you receive $ you are selling to the bank, but why is it that sometimes if you owe a supplier $ that you on some occasions are just buying $ while in others you are selling £ to buy $?
If i write which i presume is happening will i still get any marks?
Many thanks and thank you for the great lectures!
August 31, 2017 at 6:44 am
You are always selling one currency to buy the other currency, so selling pounds is buying dollars (in your example).
August 12, 2017 at 5:22 pm
Regarding part ‘b’ of example 3.
Since we are going to exercise the Option at the strike price of 1.475 could we not do the calculation as follows:
Convert on day of transaction:
$ 1 000 000 / 1.475 = £677 966
Premium Paid = £5 556
Total Payment = £683 522
There is a marginal difference of £395 (due to rounding).
With the above calculation we don’t show the profit on the Options at the day of the transaction.
Would we lose marks if we do it the above way opposed to calculating the transaction at spot and adding/ removing the profit or loss and then adding the premium?
Thanks for the great lectures!
August 13, 2017 at 8:57 am
You would still get the marks (but the difference is not due to rounding – it is due to the fact that you can’t actually use options on the exact amount because of the fact that it must be in fixed size contracts).
August 16, 2017 at 10:26 pm
August 17, 2017 at 8:58 am
You are welcome 🙂
August 10, 2017 at 1:42 pm
Thank you for your lecture, it’s really helpful. However, is there any way that we can do to not under- or over-hedging when we round up or down the number of contracts?
August 10, 2017 at 4:22 pm
There is virtually always going to be an over or under hedge (unless they are OTC options because then we can get the option on the exact amount and are not restricted by contract sizes).
The way to protect against the risk on this amount is to use forward rates. In the exam but all means show the calculations using forward rates on the over/under hedge, but it is a monitor point (because the amount will always be relatively small) and so it is enough just to mention the possibility.
August 10, 2017 at 8:20 pm
Thank you so much Sir, that really helps.
August 11, 2017 at 6:07 am
February 17, 2017 at 2:40 pm
Can I ask, when we convert the premium from dollars to pounds, why do we use the buy rate of $£1.475? In my mind I’m thinking that I’m effectively selling dollars, but have I got this bit confused? Thanks!
February 17, 2017 at 4:40 pm
We are having to pay the premium in dollars and therefore we need to buy dollars to make the payment.
February 18, 2017 at 12:11 am
Thanks for answering my question. I’ll have a proper think about it on the morning, I don’t think it will sink in just now!
February 18, 2017 at 7:21 am
December 1, 2016 at 2:57 pm
what if we are not told which strike price to use to buy the options? How do we work out the most suitable strike price?
November 7, 2016 at 10:38 am
Assuming our transaction was payable in March and the only available options were Apr and May – so we go for Apr. In such a case, how do we calculate the profit on the option (do we still use the strike price of 1.475 and the spot price in March?)
Re: Casasophia Co
Thanks in advance
November 7, 2016 at 2:42 pm
Yes you would – effectively we would assume that they were American style options which could therefore be exercised at any time up to the last day. (European options can only be exercised on the final day – the way round it would be to sell the options on the date of the transaction).
However, it is unusual these days to actually be asked to calculate the profit on the options. What is more likely is to be asked to prove you know the effect of them – i.e. effectively limiting the worst that can happen, and calculating this limit.
(In future it is best to ask this sort of question in the Ask the Tutor forum, because I do not always see comments on lectures)
October 17, 2016 at 12:54 pm
I have a question just for my understanding what if the strike price(1.4750) was lower than the spot rate(1.4100) what would have happened??? Are we than be paying the difference instead of claiming(31648) as done in the lecture
October 17, 2016 at 1:21 pm
No. With options you have the right to exercise them, but you do not have to. That is the attraction of options (but that is why you have to pay a premium).
You will only exercise them if it is in your favour.
October 18, 2016 at 12:02 pm
Thanks I got it
October 18, 2016 at 12:05 pm
September 8, 2016 at 8:17 am
Great lecture as always!
just one question though, Why have we taken the ‘claim’ or ‘profit’ from the spot of the exchange rate ? there isn’t any spot given for the option in April, it should have been (No. of contracts X Size of contracts) X (difference between the sell strike price & the buy strike price of the option – which isnt given),
Claim = 22 x 31250 x [1.475 – (price of that option on this date of transaction, the spot price of the option – which isnt given)]
this also brings another question to mind, are options limited too? if American or EU ? like futures ? and if so, then is it possible for a question to expect us to find the Basis Difference and come up with a figure for a future Strike price of an option on a given date?
September 8, 2016 at 10:53 am
The option is the right to convert at the strike price.
If we do not exercise the option then we simply convert at whatever the spot rate is.
If we do exercise the option then we effectively convert at the strike price (but as I show in the lecture, strictly we convert at whatever the spot is, and then claim back the difference between the exercise price and the spot).
We are not buying and selling options (they are not futures) – we are buying options and then later we decide whether or not to exercise them.
The exercise price is fixed at whatever we chose when we bought them and does not change.
It is only options that are either American style or European (not EU) style – not futures.
Basis risk is of no relevance for options, and again the strike price is fixed when we buy them so there is no such thing as a future strike price to calculate.
September 8, 2016 at 5:39 pm
Got it! thank u so much for the clarification!
September 9, 2016 at 6:47 am
June 14, 2016 at 3:21 pm
Dear sir why not we exercise the option $1m ÷1.4750= £677966 this is the amount which we need to pay instead of doing claiming the receipt and add premium in this amount as by doing spot rate and then claiming receipt we get the £677572 its little diffrent.. but can we do direct exercise ?
June 14, 2016 at 5:12 pm
Because the option can only be bought in fixed size contracts.
June 14, 2016 at 2:22 pm
At 2.43 screen get stuck but voice coming i canot see what you are writing .please solve issue.
The video is working fine – it must be a problem with your internet connection.
Try again and hopefully it will be OK.
May 9, 2016 at 6:12 am
1) In the case of deciding the strike price do we have to consider the cost involved? Which means lowest premium? Or we must work for all strike prices given?
2) What is the difference between Long position and short position?
3) Is it true that American options are better than European?
May 9, 2016 at 7:12 am
Please ask this sort of question in the Ask the Tutor Forum, rather than as a comment on a lecture 🙂
May 6, 2016 at 5:43 am
Sir, in the total premium calculation
22x GBP31,250 X $0.012=$8250
when changing $8250 into GBP
as it is in spot market and simply change GBP into $,
so that i thought we should use sell $ and buy GBP
and I used 1.4870 ($/GBP 1.4840-1.4870)
(separately think that we are in the buying $ position)
I hope to get to hear the comment ! and thanks for the lectures : )
May 6, 2016 at 7:07 am
Because the premium is calculated in $’s (and they are in the UK), they need to buy $’s and therefore it is the lower rate that is used. (Using the higher rate would mean they paid less, which could never be the case 🙂 )
May 6, 2016 at 5:26 am
the display of GBP is not shown..
? is GBP
March 5, 2016 at 12:10 pm
Please solve it.
XYZ UK based company have to pay $2m in july.
Spot rate now is $/£ 1.5350–1.5370.
Strike price is 1.525.
Contract $/£ £31250
July spot rate is $/£ 1.460–1.4620
No of contracts 42
Premium is £10688
We should exercise the option in order to get small amount of payment.
-Transaction at spot rate give £1369863 (PAY)
-Claim amount Receipt is 42x31250x(1.525 – 1.46) =$85312.5/1.4620
which is £58353(REC)
But this do not match with the book answer, Instead of using the higher rate (1.4620) if i use the the lower rate(1.460) then answer match. WHY?.
I mean we are receiving the amount so should use higher rate.
March 5, 2016 at 2:54 pm
You must ask questions like this in the Ask the Tutor Forum and not as a comment on a lecture.
January 19, 2016 at 8:15 pm
@John Moffat i just want to know that in the lecture above when we exercised the option we claimed the difference 22 x 31250 x (1.4750-1.4100) just for the sake of clearing my concept we just assume that for instance the strike price is less than the spot
strike price 1.4050 spot 1.4100 -1.4120
now we do the same 22 x 31250 x (1.4050 – 1.4100)/1.4100 so over here would we be paying the dealer the difference???? as we claimed the difference earlier in the lecture above, And if we would be paying the difference than we have to buy the $ so we will be using buy rate to convert $ into pounds.
please explain me about this.
March 1, 2016 at 8:03 am
if the strike price is 1.4050, which is less than 1.4100, then we will not exercise the option. in this case, we have nothing to claim from the dealer. because the option won’t let us a loss.
March 1, 2016 at 11:47 am
Q is correct (and this is explained in the lecture also).
November 28, 2015 at 4:26 am
sir plz tell me if examiner does not specify which strike price to use.and we have to decide.then how can i select strike price out of 3 as mentioned in questions.
November 28, 2015 at 8:10 am
You cannot say which is the best strike price – you can only discuss them.
Different strike prices limit the worst that can happen, but the ‘better’ the limit the more expensive the option will be (the premium).
When we buy the option we do not know what is going to happen to the exchange rate – if it moves in our favour then we do not exercise and we still have to pay the premium.
October 3, 2015 at 4:21 pm
What if we are not given spot rate of transaction date? How will we find that if option worth exercising or not?
In June 11 past paper, Casasophia Co question has aforesaid issue.
October 3, 2015 at 4:58 pm
Due to inflation rate not given, can’t calculate from purchasing power parity either.
October 3, 2015 at 6:06 pm
P4 is testing that you understand the nature of options and how they work. On occasions you have been told the spot rate on the future date, in which case you can calculate the exact result. On other occasions (as in Casasophia) you are not given the spot rate and you are expected to show what the worst outcome would be (i.e. if the options were to be exercised) and what the relative costs are (i.e. the premiums) and then discuss/recommend. This is what the situation would be in real life when deciding whether or not to use options. Obviously in real life you would not know what the future spot rate would be at the time you were deciding whether or not to buy options.
(In future please ask about specific questions in the Ask the Tutor Forum and not as a comment on a lecture.)
August 23, 2015 at 8:13 am
im confused as to why we didnt just divide 100,000/strike price 1.475 and get 677966.10 and then add in the premium.
why go the long way of converting at todays buy rate the first 100,000 element and then adding the differece of the profit or loss element.
the former gave 677966.10 and the latter 677572.
my ears inside is shouting at me that it is because of the element of the fixed size contract but we didnt get a perfect hedge did we cuz we rounded 21.69 to 22. does the examiner have a “relevent range” answer or the former solution is also correct?
August 23, 2015 at 7:42 pm
Your ears are correct 🙂
It is because of needing to have fixed size contracts. You would not get zero marks, but you would lose marks for not dealing with the issue of contract size.
August 13, 2015 at 7:18 pm
I observe you, unlike other solutions I’ve seen, were not bothered about rounding up the number of contracts as the division didn’t give a round figure.
Isn’t it important and doesn’t it affect the eventual result or you approach has inherently nullified it’s effect.
August 14, 2015 at 6:31 am
I certainly do round the number of contracts!!
Watch again and at around 7 min 10 seconds you can see me round it up from 21.69 to 22 contracts!!
We can only deal in whole numbers of contracts and so we have to round it.
August 14, 2015 at 8:28 am
So does it matter when you are to compare 2 strike prices, if 1 gives number of contract of 22.19 while the other gives 21.9 and both is rounded to 22?
I know the premium would be different. I just want to be clear if the fractional round-up is immaterial to the outcome of the options because I’ve seen solutions which recognise over-hedging and under-hedging because of the rounded number of contracts.
August 14, 2015 at 9:31 am
If the exchange rate moves against us and therefore the options are exercised, then the outcome will obviously be different because different strike prices result in a different ‘worst’ exchange rate. The over or under hedge is a minor issue because the amount involved will be small relative to the overall size of the transaction.
Obviously if the options are not exercised then any over or under hedge becomes completely irrelevant anyway.
May 16, 2015 at 3:35 pm
Hi John, very insightful – thank you:
Quick question – confused as to why you would claim against the buy rate of the spot dollar
I.e 22 (Contracts) x £31,250 (size) x ( 1.4750 (right to sell ‘put option’) minus 1.4100 (today’s buy spot)
Why would claim against the buy spot rather than the Sell spot (1.4750 minus 1.4120), seeing as we bought the right to sell?
Why would anyone buy the option from you when the today’s spot is cheaper?
May 16, 2015 at 3:38 pm
We are not selling the option. The option is the right to sell £’s at a fixed rate (the exercise/strike price).
May 16, 2015 at 3:44 pm
Many thanks for the very prompt reply –
I think I get it: the original option was taken in the home country to sell the pound at an agreed rate (as we would need to get rid of the pound to buy the dollar in order to pay) – and we claimed this back as part of exercising the option – because our strike price was favourable to the April spot?
May 17, 2015 at 10:10 am
March 10, 2015 at 9:33 pm
Good day Sir,
Many many thanks for these lectures, they have been very helpful indeed. However, there are no lectures for foreign currency and interest rate swaps, can you kindly advise on when these will be put on the website.
Awaiting your reply.
March 2, 2015 at 9:14 am
Hi tutor, I’m stuck in options concept, I’m sorry if it’s irritating to ask some topic, please solve this one, could u plz explain where am I wrong in the solved example (example from lecture 3 on currency options- open tuition course notes)
Option position £687500
Overhedged by $14063
Selling there dollars and get local £, so divide by 1.4120
March 2, 2015 at 10:04 am
The difference between your total and the total in the answer at the back of the notes is GBP 30, which is irrelevant for the exam.
(The reason for it is the difference between the spot buy and sell rates at the date of the transaction. Strictly the method in the notes is the way it works in practice. The other way of doing it is effectively calculating the profit on the options based on 1.4120 instead of on 1.4100. However, that doesn’t matter in the exam – either way would get full marks. The reason I prefer the method in the notes is partly because it is the way it works in real life, but also because when you come to interest rate options there is no choice – it has to be done effectively that way).
February 28, 2015 at 10:55 am
Please solve this,
ABC Inc, a USA based Co.is expected to make payment of £530000 in 3 months, 3 months spot ($/£) 1.5655
strike price (£/$) 1.58, premium 2.12 in cents, contract size £31250
Premium=$11263, No of contracts are 17
Answer with BPP METHOD is $848681
Answer with open tuition
At spot rate $829715
Claim back ($7703)
Net payment =$833275
Where am I wrong?
February 28, 2015 at 11:26 am
Firstly, either you have mistyped the question or BPP had made a typing error. The 3 month spot rate is quoted $/GBP whereas the strike is quoted GBP/$ – this could not be the case.
If I assume that the strike is really $/GBP 1.58, then the option would not in fact be exercised – it would be cheaper to buy GBP’s at spot rather than at the strike.
Therefore, the end result would be to convert at spot (829715) and still pay the premium (11263) even though it was not exercised. This gives a total of $840978.
(The BPP answer you type has wrongly assumed that the option is exercised. If they did exercise, then rather than receive back money on the option they would be having to pay in money (7730). This would result in a total payment of 829715 (at spot) + pay out 7703 (on the option) + pay out 11263 (option premium) giving a total of 848681- which is the same as the BPP answer.)
It either means that BPP have got it wrong, or somewhere you have mistyped the question.
February 28, 2015 at 1:10 pm
Ok thanks you, may be BPP misprinted
But if spot is 1.5655 and strike is 1.58, it’s the payment case so exercising the option is better or not?
February 28, 2015 at 5:33 pm
It is better to not exercise the option (because multiplying the GBP 500,000 by the spot rate will mean paying fewer $’s than using the strike price).
February 28, 2015 at 10:37 am
I’ve used both types to solve a question, one that’s is in book and the one shown in lectures, but in some questions I don’t same get answers
November 27, 2014 at 9:10 pm
Slightly confused on whether we needed to buy a call or put option. Is it the reverse in an FX option for an Interest Rate Option?
September 19, 2014 at 3:07 pm
Thanks a lot sir. we appreciate your efforts to helps students. But sir Problem is that, in notes and books we have very basic example but in exam we are facing more complex question. how to handle this issue and from where we can find more material to practice.
September 19, 2014 at 5:09 pm
The lectures – as with all courses – go through the techniques needed.
The exam questions are not more complex in terms of the techniques, but certainly are more complex in terms of sorting through the information and deciding which techniques to use.
You can only master this by practicing exam-standard questions (once, obviously, you are happy with the techniques involved and really understand them) and for this – as we make clear throughout the website for all the exams – you must have a Revision/Exam Kit from one of the approved publishers, and you must work through all of the questions properly and learn from them.
If you have any problems with any of them (or with understanding the answers) then obviously ask in the Ask the Tutor Forum and we will try and help.
September 23, 2014 at 6:26 am
Thanks a lot sir
October 25, 2013 at 2:13 pm
Very useful lectures indeed..thank you..i could not find here lectures on SWAPS to hedge against excahnge risk…Why is it so??
October 25, 2013 at 3:25 pm
We do not have lectures on everything – some topics you have to study yourself from out notes and from your books.
New lectures are added as and when we have the time.
October 25, 2013 at 4:10 pm
October 25, 2013 at 5:07 pm
If you have any specific question later, then please do ask 🙂
(but please realise that we are doing all this in are spare time after work!)
November 11, 2013 at 11:22 am
Thank you sir, Your lectures are very helpful..do we have lectures on Business Valuation?
November 11, 2013 at 3:46 pm
No – sorry. However there is not much extra from what you will have learned for F9, and any extra techniques needed are covered in other chapters of the notes/lectures anyway.
November 12, 2013 at 6:36 am
Thank you sir 🙂
October 22, 2013 at 11:26 pm
I have problem in calculating cross rate,
Example, Consider the following.
Spot……………………One year forward rate
Spot………………….. One year forward rate
Now, What is the cross rate for converting SF to Dollars?
My second problem lie in foreign Tax credit, I don’t know how to calculate the value for Foreign tax credits.
Thank you for your continue support.
October 23, 2013 at 6:14 am
1 SF will buy 2.298 GBP., and 1 GBP will buy 1.7985 USD.
So….1 SF will buy 2.298 x 1.7985 USD
With regard to tax credits, if (for example) tax has been charged at 25% in one country! and the profits are remitted to another country where the rate is 30%, then there is an additional 5% chargeable in this other country
August 26, 2013 at 6:47 pm
Whether to buy Put Option or Call Option .I have tried to memorize following
US Company Receiving GBP (Any currency other than $)- PUT ( Always)
US Company Paying GBP ( Any Currency other than $)- CALL ( Always)
Non US Company Receiving – $ – CALL ( Always)
Non US Company Paying – $ – PUT ( Always)
Whether this is right way of doing and whether it would serve exam purpose.
May 5, 2013 at 3:48 pm
Why do we convert the transaction at spot of 1.4100 when we are having the option and we can get the pounds at 1.4750?
May 5, 2013 at 8:11 pm
The lecture explains this!
These are traded options and so you do not actually have the right to convert at the option rate. What happens is that you convert at the spot rate and then ‘claim’ on the options and so get back the difference.
Watch the lecture all the way through – it is all explained.
May 5, 2013 at 11:53 pm
Oh ok.. I guess I missed that! Thank you so much! 🙂
gaya s. says
April 10, 2013 at 6:22 pm
Thank you to the tutor and Open Tuition for the wonderful lecture 🙂
However I have a q on the premium part.
The premium was initially established in $ and since the company in q is a UK company, the impact should be shown in Pound and thus the need for conversion to Pound arises. I understood that part. However why was the the conversion rate used $ 1.4850 (buying rate) and not $ 1.4870 (selling rate) since we are selling $ to receive pounds?
Thank you once again for a good lecture 🙂
April 28, 2013 at 11:51 pm
Hey 🙂 I understood your question. And its a good one btw 🙂 What i believe is, since its a premium PAYABLE in dollars, we have to BUY dollars to pay for the premium. And therefore, in order to buy the dollars, we are using the Buying Rate (1.4850).
So in short, we can say, we are selling 5556 pounds to buy 8250 dollars 🙂 I hope i made sense 😀
April 29, 2013 at 10:35 am
Wahabna is correct – because the premium is in dollars, we need to buy dollars.
November 21, 2011 at 12:52 pm
Hi Markn, Thanks for your explanation. I finally understand that the tutor said, when we exercise the option, we are actually claiming back $ from the option writer. So, the currency we hold now is $, we will sell $ to buy Pound. Therefore, buy rate of $1.4120 is used. Anyway, thank you so much.
November 21, 2011 at 10:44 am
Hi Estherpang87, the reason he uses 1.4120 is because we are receiving the pounds to offset against the amount we are convering to pay the $1m. Some tutors always advise us to choose the rate in which we receive less or pay more – it’s just an exam tip. Always choose a rate that is unfavourable to you…
November 16, 2011 at 4:11 pm
Hi sir, in this example, when we calculate the amount attributable to option exercised, our working is [22 x 31250 x (1.475 – 1.4100)] / 1.4120 = 31649 pound.
In my opinion, the rate of 1.4120 is a buy rate. but in this case, we actually sell pound to buy $ to settle payment. Shouldn’t we use sell rate of 1.4100, instead of the buy rate of 1.4120?
Thank you sir.
November 10, 2011 at 12:46 pm
Dear Tutor, is it assumed that premium payable to bank in USD that’s why we are using buying ex.rate in this example? Thank you
May 16, 2011 at 10:30 am
its realy hepful
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