9.3 Derivatives markets

Consider the case of a rm that is short in the underlying product (say, US dollars).

Remember that being short in dollars leaves the rm open to the risk that the dollar

will rise. Taking out a call option in dollars provides a hedge against this risk since

if the dollar rises in value, a prot can be made on the call option. The hedger can

exercise the option at the strike price, which is lower than the rate in the spot

market. We can thus say that the call option establishes a maximum price that the

rm will have to pay for the underlying product in which it is short. Of course, it

might choose not to exercise the option but to sell it on to someone else. It would

then pay the higher spot market price for the dollars it needed but would be able to

set against this the prot made from the sale of the option.

If the spot market price falls, the hedger has to pay less for the dollars it needs and

has only to set against this the premium paid for the option. Thus, an option provides

protection against the losses that would occur if the spot price moved in one direction,

without removing the prots that might arise if the price moved in the opposite

direction. This is not the case in trading in either forward or futures markets.

The reverse arguments hold for hedgers who are long in the underlying product.

For them, a put option establishes a minimum price for the underlying product. If

the spot price falls, the premium of the put option rises and the holder can exercise

the option at the strike price (preventing a loss). Alternatively, he can sell the under-

lying product at the lower spot price, incurring a loss, but offset this with the prot

made from selling the option. If the spot price rises, the holder of the option can

benet from the higher price in the cash market and allow the option to lapse. Thus,

holding a long position in the cash market and buying a put option produces the

same result as does buying a call option when the trader has no position in the cash

market. In both cases, the holder of the option benets from a rise in the price of

the underlying product in the cash market. For this reason the combination of being

long in a product and holding a put option is sometimes known as a synthetic call

option.

Options, like futures, are highly geared (leveraged) because the options price is

only a small percentage of the price of the underlying product. Thus, when a prot

is made from trading in options, the per annum rate of prot is likely to be high.

A trader may prefer to hedge or speculate by writing options rather than by buy-

ing them, although this can be risky. Writing a call option offers protection against

a price fall since in this case the option is not exercised and the writer collects the

premium on the option. In the same way, writing a put option offers protection

against a price rise. Writing options is only effective, however, if the price changes

are relatively small, and it carries the risk that if prices go against the writer, the loss

may become very large. For example, a trader who writes a call option on the £/$

exchange rate at a strike price of $1.80 agrees to sell sterling at that price. If sterling

increases in value and the writer is short in sterling, he will need to acquire it in the

spot market at the higher price. The amount he loses will then depend on the size

of the contract (for example, £31,250 per contract in the £/$ option offered by the

Philadelphia Stock Exchange) and the amount the price rises. If sterling rose to

$1.90, the loss would be $3,125 per contract (31,250 $0.10). Unlike the buyer, the

writer cannot abandon a losing option.

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

The trading of options contracts on organised exchanges guards against the risk

that the writer of an option might default on it by not being able to deliver the under-

lying product to the holder of a call option or to pay the holder of a put option for

the delivery. To buy an option, a trader must have an account with a brokerage rm

holding a membership on the futures and options exchange. The buyer pays for the

option at the time the contract is written and no further payments are required apart

from a commission to the broker. However, because the writer of an option enters

into an open-ended commitment, he may need large nancial reserves to meet his

obligations. A writer may write a covered call (the writer already owns the underlying

product and deposits it with the broker) or a naked call.In the latter case, the broker

may require substantial deposits of cash or securities to ensure that the writer is able

to meet his commitment. As in a futures market, the buyer and writer of an option

have no obligations to a specic individual but to the clearing house of the exchange,

which manages the exercise process and the standardisation of contract terms.

All currency options are for the US dollar against a non-dollar currency, and a call

option gives the right to buy the non-dollar currency. Exercise prices are stated in

US cents. The holder of a call option gains if the non-dollar currency rises in value;

the holder of a put option gains if the non-dollar currency falls in value. Box 9.3

provides information on $/£ options.

Box 9.3

Currency options – an example

On 15 June 2006, the Financial Times provided the following information: $/£ options

offered by CME

Strike

Calls

Puts

Price	Sep	Dec	Mar	Sep	Dec	Mar
1.820	4.42	5.64	–	1.88	2.83	–
1.830	3.75	5.05	–	2.20	3.12	–
1.840	3.13	4.5	5.84	2.57	3.55	4.51
1.850	2.99	–	–	2.99	–	–

Previous day’s volume: calls 211, puts 46

Previous day’s open interest: 9,445

That is, a call option giving the right to buy sterling at a rate of £1 $1.820 on or before

30 September 2006 would have cost, at the close of trading on 14 June 2006, 4.42 cents

per pound. If we assume that each contract had a value of £31,250 as with the Philadelphia

Stock Exchange contract, each contract would have cost 31,250 4.42 cents $1381.25.

You should note the following points:

l	At a strike price of $1.820, the premiums on calls were much higher than those on puts, but at a strike price of $1.850 the premiums on calls and puts for 30 September were the same.

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