Wednesday, March 28, 2012

Know your options

Foreign exchange transactions are entered into either for hedging a risk or to trade / speculate.  If it is hedging, treasury (based on budgeted rate or FX target rate) decides the timing of transaction.  If it is one of speculative trading, then it is dependent on internal view.  I came across (what appears to be) a simple structure which left me confused as to what could be the objective of entering into a transaction such as this.  Let me take you through an example before we go further.

Indicative market quotes
USD/INR spot        - 51.00
1 month forward    -  51.50

Option strategy / structure
Buy USD put    @ 51.50 (A)
Sell USD call   @ 51.50 (B)
Sell USD put    @ 51.00 (C)

Maturity              1 month
cost                     zero

The strategy under discussion is a combination of options A, B and C.  This structure hedges export exposures (dollar receivable). Option A and B together is nothing but a synthetic forward, (i.e) if USD/INR at maturity is below 51.50 option A gets exercised and and if USD/INR is above 51.50 then option B gets exercised; whichever way, the effective rate would be 51.50 making it work like a forward.  This strategy also has a third leg (option C).  Below is a comparison of  this strategy with a simple forward contract (51.50) under two scenarios:

(1) if market at maturity is <51,
  • this strategy is 50 paise better than spot (at maturity) 
  • whereas a forward contract will be better than spot (at maturity) and above structure.  For instance, if  USD/INR spot, at maturity is 45, forward contract is Rs.6.5 better than market  whereas the above strategy is Rs.0.50 better than the market (spot at maturity)
(2) If market at maturity is > 51, then the above structure works just like a forward

This strategy CAPS YOUR GAIN AT 50 PAISE BUT YOU COULD LOSE A WHOLE LOT.  An option which has a limited upside and a substantial risk - Beats the purpose?

Going back to where we began, why would a corporate enter into this transaction?  I wouldn't think it's for hedging as this does not protect any particular level. If it is speculation, what is the view?  If the view is one of rupee depreciation, this strategy doesn't work; if  it is otherwise, forward is a better bet. Or it's the "zero cost" temptation? Beats me! 

 "Zero cost options" have been around for a long time and could turnout to be most expensive in hindsight.  It is important for corporates to check (1) if the offered strategy meets their hedging needs and / or confirms to their view and (2) scenario analysis before closing the trade.  

So are options bad?  Not if you know what you are getting into.  As cliched disclaimer goes  "please read the offer document carefully before investing". 

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