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  2. Thank you for your lectures.

    i seem to mix up the currency of the strike price and spot rate you use.

    I normally would use this as a guide:
    -A uk company to pay $1m
    depending on the exchange rate format e.g $/GBP 1.4850 or GBP/$ 1.4850, then will i decide to divide or multiply. here you divided the 1m with the strike price to get the amount you need in pounds(to further determine number of contracts). However shouldnt we have multiplied?

    same thing we did when we were to convert at spot on transaction date. 1m$ divided by GBP1.4100 TO get GBP 909,220.

    i am missing something? shouldn’t we have multiplied to get GBP and not divide?

    • The strike price is quoted in $’s per GBP, so to convert from $’s to GBP we need to divide by the strike price.
      Have you watched the first of the lectures on foreign exchange risk management, where I explain how to decide on how to use the exchange rate?

  3. Hi John,

    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?

    • I’m confused about this as well. Since this is an option and we’ve already converted at the strike price -> isn’t the profit we would have made included inside this figure? Why exactly are we claiming the difference when there should be no transaction at spot.

      • The way traded options work is that you always convert the transaction itself at spot, and then get back from the option dealer the difference between between the spot rate and the exercise price (assuming you do exercise the option). The net effect is as though you had converted at the option price. For currency options this is not a big issue, but it matters a lot for interest rate options later.

  5. Hi John

    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 拢 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!

    Leanne

  6. Hello John

    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 = 拢677 966

    Premium Paid = 拢5 556

    Total Payment = 拢683 522

    There is a marginal difference of 拢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?

    Kindly advise.

    Thanks for the great lectures!

  7. Dear Sir,

    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?

    Regards,
    Dino

    • 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.

  8. Can I ask, when we convert the premium from dollars to pounds, why do we use the buy rate of $拢1.475? In my mind I’m thinking that I’m effectively selling dollars, but have I got this bit confused? Thanks!

  10. Dear John,

    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

    • 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)

  11. 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

  12. 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),

    simply put;

    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?

    • 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.

  13. Dear sir why not we exercise the option $1m 梅1.4750= 拢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 拢677572 its little diffrent.. but can we do direct exercise ?

  15. Dear Sir,

    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?

  16. 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 : )

    • 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 馃檪 )

  18. Please solve it.
    XYZ UK based company have to pay $2m in july.
    Spot rate now is $/拢 1.5350–1.5370.
    Strike price is 1.525.
    Contract $/拢 拢31250
    July spot rate is $/拢 1.460–1.4620
    Solution
    No of contracts 42
    Premium is 拢10688
    We should exercise the option in order to get small amount of payment.
    -Transaction at spot rate give 拢1369863 (PAY)
    -Claim amount Receipt is 42x31250x(1.525 – 1.46) =$85312.5/1.4620
    which is 拢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.

  19. @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
    Supposedly:
    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.

    • 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.

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