CALL OPTION

• The Call Option establishes a ceiling for the exchange rate,

and the option can be used to hedge foreign currency
outflows (potential payments)
• If S>X (Where S is the Spot price and X is the exercise or
Spot exchange rate)
=> Profit increases one-for-one with appreciation of the
foreign currency. At (X+P) the holder of the option breaks
even (ceiling price). Here P is the Premium.
• If S<X
=> The call option will not be exercised, because the holder is
better off buying the foreign currency in the spot market. The
holder will have a negative profit reflecting the premium, P
Profit Profile for a Call Option

Profit/Loss Payoff
Region

X+P

X
Exchange
-P
Rate
 Put Option
• The Put Option establishes a floor for the exchange rate, and
the option can be used to hedge foreign currency inflows
• If S>X
=> The call option will not be exercised, because the holder
is better off selling the foreign currency in the spot market.
The holder will have a negative profit reflecting the premium,
P
If S<X
=> Profit increases one-for-one with depreciation of the
foreign currency. At (X-P) the holder of the option breaks even
(floor price)
 PUT OPTION

Profit/Loss
Payoff Region

Exchange Rate

X-P X
-P
 EXAMPLE: Call Option
• The holder of a call option expects the
underlying currency to appreciate in value.
• Consider 4 call options on the euro, with a
strike price of 152 ($/€) and a premium of 0.94
(both cents per €).
• The face amount of a euro option is €62,500.
• The total premium is:
$0.0094·4·€62,500=$2,350.
Call Option: Hypothetical Pay-
Off
 EXAMPLE: PUT OPTION
• The holder of a put option expects the
underlying currency to depreciate in value.
• Consider 8 put options on the euro with a strike
of 150 ($/€) and a premium of 1.95 (both cents
per €).
• The face amount of a euro option is €62,500.
• The total premium is:
$0.0195·8·€62,500=$9,750.
Put Option: Hypothetical payoff
Profit
at a spot rate of 148.15
Payoff Profile

Break-Even

148.05 150
0 Spot Rate
-$500 148.15

-$9,750

Loss In-the-money At Out-of-the-money

 Comparing Futures and Options
The value of a futures contract at maturity (date t+n) to purchase one
unit of foreign currency will be:

Value

0 St+n
Zt,t+n

The value of the futures contract

is zero at maturity if the spot rate
at maturity is equal to the current
futures rate.
Consider now the value of an option to purchase one unit of
foreign currency at that same price (i.e. a ‘call option’ with a
strike price X equal to Zt,t+n ):

Value

0 St+n
X

The value of the call option

begins increasing when the
exchange rate becomes larger
than the exercise price - when the
option becomes ‘in the money.’
But we’re missing something. While a futures contract has an
expected return of zero, the value of the option looks like it is
always positive…

Value

0 St+n
X
Hence, anyone taking the opposite side of the transaction
(‘writing’ the option) will demand a premium (C) that makes the
expected value zero once again:

Value

0 St+n
C X

Regardless of the outcome,

the option’s value is reduced
everywhere by the certain
payment of its premium.
The value of an option to sell one unit of foreign currency (a
‘put’ option) at a strike price equal to a corresponding futures
contract price will have similar properties:

Value

0 St+n
X
 The Straddle Strategy
• During highly volatile market conditions investors
use a buying straddle strategy.
• On the other side of the transaction, when they
expect neither sharp rise nor sharp fall in the
exchange rate, they use a selling straddle
strategy.
• it consists in buying (in the case of a volatile
market) or selling (in the case of a stable
market) both a call and a put option at the
same strike price and for the same maturation
date.
The Straddle Strategy
 The Strangle Strategy
• It consists in buying or selling a call and a
put option at different strike prices.
• The strangle buying strategy has unlimited
profit potential if the exchange rate moves
enough in either direction. The value of a
strangle option increases along with the
volatility of the underlying currency.
The Strangle Strategy