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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
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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
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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
