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Corporate Uses and Abuses of Currency Options Prof Ian Giddy New

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					Giddy                                                                 Options: Uses & Abuses/1




                                       Corporate Uses and Abuses
                                          of Currency Options

                                             Prof. Ian Giddy
                                           New York University




                    Forwards vs Futures vs Options

                    l      Good credit: Forward usually best
                    l      Sometimes, Money Market Hedge better
                             u Perfectmarket: same (covered int. arb.)
                             u Imperfect market: MMH may be better

                    l      Credit problem: Futures
                             u But:
                                  limited and standardized
                             u Requires margin and daily settlement

                    l      Uncertain future cash flows:
                             u Liquid  instrument (futures/forwards to assure
                               flexibility
                             u Options sometimes advisable

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                    Using Currency Options

                    Known cash flows + option hedge =
                     naked option
                             uHedging  a known position
                             uCovered call writing
                             uHedging with “cheap options”
                             uHedging with “free options”
                             uHedging contingent risk
                             uOptions receive favorable accounting
                              treatment

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                    Using Currency Options:
                    1. Hedging a Known Position

                    l      Example: Buy a Swiss franc put to
                           hedge a royalty payment to be received
                           from Switzerland

                        Gain           +
                       or Loss         0

                                       -

                                           Value of Swiss franc

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                    Combining Options

                                                              Long a currency


                              Gain
                                                                     Plus:
                             or Loss                               Buy a put


                                                                     Net effect:
                                                                  Like buying a call

                                       Value of Swiss franc



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                    Put-Call Parity

                                                                  Sell a Call


                              Gain
                                                                    Plus:
                             or Loss                              Buy a put


                                                                  Net effect:
                                                               Short the currency

                                       Value of Swiss franc



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                    Don’t Kid Yourself
                                                                                           SHORT CALL
                                             Profit   LONG CALL                   Profit   PLUS LONG
                                                      PLUS SHORT                           FORWARD
                                                      FORWARD                              CREATES
           Option combinations:                       CREATES
                                                      SYNTHETIC
                                                      LONG PUT
                                                                                           SYNTHETIC
                                                                                           SHORT PUT

                                           +                                      +

            Owe currency                   0
                                                          Strike
                                                                                  0
                                                                     Forward                      Strike     Forward Rate

             + buy call                    _                                      _



             = Buy put
                                                      LONG PUT                                  SHORT PUT
                                             Profit   PLUS LONG                   Profit        PLUS SHORT
                                                      FORWARD                                   FORWARD
                                                      CREATES                                   CREATES
                                                      SYNTHETIC                                 SYNTHETIC
                                                      LONG CALL                                 SHORT CALL

                  Own currency             +
                                                          Strike
                                                                                  +


                  + buy put                0
                                                                   Forward Rate
                                                                                  0
                                                                                                  Strike     Forward Rate

                                           _                                      _

                  = Buy call
        Copyright ©2002 Ian H. Giddy                                                        Options: Uses and Abuses 13




                    Using Currency Options:
                    2. Covered Call Writing

                    l      ICI proposes...

                                       +                            =




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                    Using Currency Options:
                    3. Hedging with “Cheap Options”

                    l      Example: Buy an out-of-the-money put
                           to hedge a Swiss franc receivable


                                       +         =

                    l Question: When should a firm buy ATM
                      options?
                    l Answer: When the firm’s view of
                      volatility exceds that of the market
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                    What Influences Option Prices?

                    l Forward relative to strike
                    l Time to expiration
                    l Volatility
                    l Interest rate

                     Option
                      Value




                                                         Currency Value

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                    Using Currency Options:
                    4. Hedging with “Free Options”

                    l      Currency collar or range forward
                           l Eg Exposure is obligation to pay for
                             Japanese imports in 60 days


                                                +                 +


                                       =
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                    Case Study: “Options Trip”


                                                    $10 million

                                                +                 =


                                  $30 million

                +                               =




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                    Using Currency Options:
                    5. Hedging Contingent Risk

                    l  Example 1: T.I bidding
                     to supply chips to Saudi Arabia
                    l Example 2: ABB lobbying to win high-
                       speed rail contract in Florida




                    l Problem: Wrong contingency
                    l Solution: Event-contingent options
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                    6. Using Options to get Hedge
                    Accounting Treatment

                    l Pfizer, the US drug company, uses
                      forwards to hedge short-term foreign-
                      currency payables and receivables
                    l Pfizer uses long-dated options, as far
                      out as 2 years, to hedge anticipated
                      sales. This gets expensive!
                    l Reason: GAAP would treat forwards
                      used to hedge future, uncertain, sales
                      as speculative, to be marked-to-market.
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                    When Should Companies use Options
                    to Hedge?

                    l      Hedge natural exposure
                             uExample:        Reeves sells printing blankets
                                   with fixed local-currency prices in Europe
                    l      Hedge against extreme events that
                           threaten the company’s business.
                             uExample:     GE could buy deep out-of-the-
                                   money options on yen.




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                    When Use Options to Take a View?

                    l View on direction
                    l View on volatility
                                       Direction: Currency      Currency    No trend
                                                     rising     falling
                                       Volatility
                                       Volatility    Buy call   Buy put     Buy
                                       increasing                           straddle
                                       Volatility    Sell put   Sell call   Sell
                                       falling                              straddle
                                       No trend in   Buy        Sell        Arbitrage
                                       volatility    forward    forward




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                    Why Use Currency Options?

                    l Protect against downside risk
                    l Earn income from covered option
                      writing
                    l Buy “cheap options”
                    l Buy “free options”
                    l Hedge event-contingent risk
                    l View on both volatility and direction
                    l Hedge against financial distress

        Copyright ©2002 Ian H. Giddy                     Options: Uses and Abuses 28




                    Which Instrument?

                    Identifiable        Debt, swaps,
                    exposure            forward contracts
                    Uncertain exposure Instruments with
                                        flexibility, such as
                                        forwards and futures
                    Exposure that       Deep-out-of-the-
                    threatens financial money options
                    distress


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                    A Hedging Roadmap


                                       Motivations for Hedge


                     Driven by                Driven by company
                   company views                      needs


            Volatility: options,          Company has          Company has
                 Direction:                 economic              natural
              forwards, debt                exposure              hedge



                      Market risk              Forwards,
                                                                No need for hedging
                        remains               swaps or debt

        Copyright ©2002 Ian H. Giddy                                     Options: Uses and Abuses 30




                    Contact Info

                    Ian H. Giddy
                    NYU Stern School of Business
                    Tel 212-998-0426; Fax 212-995-4233
                    Ian.giddy@nyu.edu
                    http://giddy.org




        Copyright ©2002 Ian H. Giddy                                     Options: Uses and Abuses 32

				
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