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If I want to buy currency on 1st of March and was only given option to buy in Feb Feb or May then which one I should buy and why?
Many thanks
Choose May option. (always date after)
On 1st March if the market price is lower than May option then buy it from market and reverse the option. and vice versa
it is what i know
If i’m wrong please ractify me- Topics: 0
- Replies: 111
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If it is an American option, you may buy the May one because you can exercise it at any time before the maturity date. If it is an European option, it is useless to buy the May one because you must buy the foreign currency at the spot market in March. You merely waste money to buy an option that you will never exercise.
To buy a Feb option should be more logical but you will have 1-month cash flow implication when exercising it in February while using the money in March.
Finally, option need not reverse because the buyer has no obligation at all.
Kepriad’s suggestion would be correct if it is a future contract.hey sosologos,
you said..”If it is an European option, it is useless to buy the May one because you must buy the foreign currency at the spot market in March. You merely waste money to buy an option that you will never exercise..”
I think even if we cannot exercise May European option on 1st march,,we can sell it in option market to realise the gain..if we made loss on commercial transaction..and vice versa..what do u say..correct me if i m wrong- Topics: 0
- Replies: 111
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Anjan are right that we may sell the option to realise some gains to offset the commercial loss. However, the hedging effect of buying a May European option is trivial. Firstly, you cannot definitely lock your position at the very beginning. Secondly,options are leveraged instruments so that what you pay and what you gain are the premium only.
hi sosologos,
you said we cannot lock our position at the very beginning. I am sorry i could not understand this…could u please elaborate..
if i pay premium to buy european options and at the day of transaction could not exercise to offset my loss on commercial transaction…i can realise the benefit of exercising through selling options and receiving premium which would be more than what premium i paid while buying..then only risk left would be basis risk or size of contract risk.. correct me if i am wrong- Topics: 0
- Replies: 111
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I would like to illustrate my point with some assuming data: A US trader needs to pay GBP62,500 in Mar. The premium for GBP Feb and May 14200 call option quote are 1.68 and 2.15 cents respectively.
If the trader’s payment is at Feb, everything is straightforward. He should buy the 1 contract of Feb GBP call at $1,050 (i.e. 62,500 x $0.0168). His downside position has been locked to 1.42 now.
However, the payment is at Mar. If the trader buys the May option at $1,344 (i.e. 62,500 x $0.0215). At Mar, the trader has to buy GBP at spot rate to settle the GBP payment. If he still exercise the option at May, he would be long in GBP because he has closed his short position at Mar. Of course, the trader may sell the GBP immediately but no one can guarantee the movement of the GBP.
If he sells the call option at Mar, he may earn some premium, say, double at 4.3 cents. His gain is just $1,344!
Therefore, buying the Feb option is a more sensible option. Firstly, its premium is cheaper. Secondly, the trader may exercise the option at Feb and use money market hedge for the 1 month time lag.
say today is 1st january and as a US trader if i need to buy GBP 62,500 at end of March to pay my suppliers…why would i buy Feb option leaving still 1 month of exposure and as you said use money market hedge or other derivative for 1 month time lag..
If you mean exercising Feb option at Feb end and depositing GPB for 1 month in GPB money market generating interest and withdrawing at end of march to pay suppliers..then i would be exposed to GPB interest rate fall between now to deposit day..this would be more complex..as it would involve two techniques to hedge my position..
why not to prefer may option?…and selling in march to cancel out my risk..which would hedge my position with least effort then to what u propose…selling would nearly equate to exercising..coz if it seems exercising is beneficial at end of march..than that benefit would be included in its increased price..so selling and exercising would mean same except little difference that may be caused by basis risk…but for this little basis risk why to get expose to more risk by entering two transaction instead of one….- Topics: 0
- Replies: 111
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By buying the Feb option, the trader’s position has been locked at 1.42. Locking a position is essential in hedging which purpose is to reduce risk in future cash flow. He may suffer some interest loss by depositing one month of GBP but the loss is an avoidable cost for hedging a appreciated GBP according to the interest rate parity theory. Let’s assume that the interest rate of US and UK are at 20% and 2% p.a., quite a crazy gap! The interest loss is $1,331.25 (62,500 x 1.42 x 18%/12). Anyway, the loss does not constitute any interest rate risk because it is certainly known at Feb.
If the trader buys the May option, he may sell the option at Mar to earn $1,344 provided that the premium can double. However, if I use the interest rate parity theory to calculate the appreciation of GBP for a 3-month period (from Jan to Mar), the spot rate at Jan should be 1.3591 for a Mar rate at 1.42). You will suffer a FX loss of $3,806 (i.e. 62,500 x (1.3591 – 1.42)). In other words, you will make a net loss of $2,462 (i.e. $1,344 – $3,806). I agree that you may make gain at more than quadruple premium. The crux of the problem is that you are not hedging because you are betting for the future, i.e. betting for the premium appreciation and for the exchange rate. Nothing can be certain until Mar.
by using Feb option we would be exposed to 1 month time lag…
if spot price were to more than 1.42 at Feb end say 1.45…you would exercise at 1.42 total cost (62500*1.42=88750+1050=$89800+interest loss as you calculated 1331.25) gives total cost of $91131.25.
if spot price at end of march will be say 1.47…i would be able to sell my option to not only cover my premium but some extra gain as well..precise calculation involve using BSM model..i wont use here…but my total cost would be (62500*1.47=91875- gain on option which would be made of intrinsic value + time value)…if we take only intrinsic value (1.47-1.42) *62500=$3125 less premium initially paid $1344) gain on option would be $1781…then total cost would be 91875-1781=$90034 which is less then using Feb option…
option gives right without obligation to lock our position….buying may option at exercise price of 1.42 effectively gives us right to lock our position at march even if we cannot exercise it..(because we could return to our exercise price of 1.42 by making profit on sale)..by buying may option i am not gambling on premium..i am just ensuring my forex risk is hedged till march with just one transaction and hence at lower cost and less complex than by using two transactions)
Frankly speaking as treasurer i would use option only when my exposure is uncertain(or when other derivatives are not available)…coz my aim would be to hedge not speculate..so I am assuming on these examples that paying GPB 62500 is uncertain..- Topics: 0
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The foremost question is what is your purpose, hedging or speculation? You will definitely make profits on buying a GBP call option if the GBP goes up, but on one can guarantee it until you exercise or sell it. However,the principle of hedging is to reduce the risk of your future cash flow.
The trader might be stupid to buy an option at 1.42 but the Feb spot is 1.35 but my cash outflow at Mar has been locked to 1.42 at worst. He should take the opportunity to let the option lapse and use a money market hedge at 1.35 in Feb. Don’t forget that your May option will become out of money when the Feb spot is at 1.35. You are not likely to get any profit by selling the option at that time. If the spot at Feb is higher than 1.42, you must have a quadruple premium on selling in order to cover the loss in FX. Of course, you may keep the option. With the payment has been settled at Feb, you are now on speculation.
Finally, I only say that buying a Feb option is better than buying a May one from hedging perspective. It might not be the best at all. If the trader believe that he is lucky enough, he may simply leave the position open and bet for a depreciated GBP. Conversely, he may consider to use the money market at day 1; alternatively, forward and futures might not be bad.
our aim is to hedge our position as on today (1st January) I am sure you would not be in hedged position if you use Feb option coz you are relying on money market hedge or other derivatives for 1 month time lag…there could be so many what if question..like
1. what if there is policy to use only option for hedging..?
2. what if company does not have access to money market for GBP depositing?
3. Even if company has access to money market hedge why not to use it from 1st day instead of using option and then money market hedge..what is logic of using two hedge technique for one transaction..?
4. Also we are uncertain on 1 Jan what would be forward rate or future price at end of Feb…
5..Again if we intended to rely on other derivatives for 1 month time lag…why not to use them from very 1st day…instead of first using option(costly than other derivative) and other derivative for 1 month time lag…
6..I would again like to stress my point that if spot price were to increase both on Feb end and March end…say 1.45 at Feb end and 1.47 at Mar end…as i calculated earlier it would be far beneficial to use may option..
In conclusion considering above uncertainty as of today 1st Jan using Feb option would only hedge upto Feb end..after that relying on other derivative as on today is like taking risk as on today…why not to pay little extra premium(1344-1050)=$294 to hedge our position till our exposure date..i.e till 31 march..
I would again raise one important point behind my argument that using May option would not mean that i would lose advantage of exercising at 31 march..even if it is European option (selling at 31 march would nearly equate to exercising due to difference in change in spot price not equaling to change in option price..this would be minor)…
finally I would still stick to my decision to use May option as better hedging as on today 1st Jan….
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