Currency Derivatives

1) a call option on Canadian dollars with a strike price of $.60 is purchased by a speculator for
a pre­mium of $.06 per unit. Assume there are 50,000 units in this option contract. If the
Canadian dollar's spot rate is $0.65 at the time the option is exercised, what is the net
profit per unit and for one contract to the speculator? What would the spot rate need to
be at the time the option is exercised for the speculator to break even? What is the net
profit per unit to the seller of this option?

To calculate the net profit per unit for the speculator, we need to first calculate the total cost
of purchasing the option, which is the premium per unit multiplied by the number of units in
the contract:

Total cost = premium per unit x number of units

Next, we need to calculate the payout to the speculator at the time of exercise. Since the
spot rate is $0.65 and the strike price is $0.60, the speculator can exercise the option and
buy Canadian dollars at the lower strike price, then immediately sell them on the open
market at the higher spot rate. The payout per unit is:

Payout per unit = spot rate - strike price

Therefore, the net profit per unit for the speculator is:

Net profit per unit = payout per unit - premium per unit
Net profit per unit = $0.05 - $0.06
Net profit per unit = -$0.01

Since the premium paid is greater than the payout, the speculator incurs a net loss of $0.01
per unit.

To calculate the net profit for one contract, we simply multiply the net profit per unit by the
number of units in the contract:

Net profit for one contract = net profit per unit x number of units
Net profit for one contract = -$0.01 x 50,000
Net profit for one contract = -$500

Therefore, the speculator incurs a net loss of $500 for one contract.

To break even, the spot rate at the time of exercise needs to be equal to the sum of the strike
price and the premium per unit:

Breakeven spot rate = strike price + premium per unit

Therefore, the spot rate at the time of exercise needs to be $0.66 for the speculator to break
even.

The net profit per unit to the seller of the option is simply the premium received per unit:

Net profit per unit to the seller = premium per unit

Therefore, the seller of the option earns a net profit of $0.06 per unit, or $3,000 for one
contract.

2) If the Australian dollar's spot rate is $0.74 on the expiration date and the strike price of the
put option is $0.80, it does not make sense for the speculator to exercise the option. This is
because exercising the option would involve selling Australian dollars for $0.80 when they
can be sold for $0.74 on the open market, resulting in a loss. Therefore, the speculator
should let the option expire.

To calculate the net profit per unit for the speculator, we need to first calculate the total cost
of purchasing the option, which is the premium per unit multiplied by the number of units in
the contract:

Total cost = premium per unit x number of units

Since the speculator did not exercise the option, the net profit per unit is simply the negative
of the premium per unit, since the speculator has lost the premium paid:

Net profit per unit = -premium per unit

Therefore, the net loss per unit for the speculator is $0.02.

To calculate the net profit per unit to the seller of the put option, we need to consider the
scenario where the speculator does exercise the option. If the speculator were to exercise
the option, the seller would be obligated to purchase Australian dollars at the strike price of
$0.80, even though they can be purchased on the open market for $0.74. Therefore, the net
profit per unit to the seller is:

Net profit per unit to the seller = premium per unit

Therefore, the seller of the option earns a net profit of $0.02 per unit, or $20 for one
contract.
3) Longer­term currency options are becoming more popular for hedging exchange rate risk.
Why do you think some firms decide to hedge by using other tech­niques instead of
purchasing long­term currency options?

There could be several reasons why some firms decide to hedge their exchange rate risk
using other techniques instead of purchasing longer-term currency options:

• Cost: Long-term currency options can be more expensive than other hedging
techniques, such as forward contracts or futures contracts. The premium for
a long-term currency option can be higher due to the longer time period
involved and the higher volatility of currency markets over longer periods.
• Liquidity: Longer-term currency options may have lower liquidity compared
to other hedging instruments, which could make it more difficult for firms to
find counterparties willing to trade such options. This could limit the ability
of firms to enter into such hedges.
• Flexibility: Longer-term currency options are less flexible compared to other
hedging instruments such as forwards or futures. Once a firm has purchased
a long-term option, it is locked into a specific exchange rate and may not be
able to adjust its hedging strategy if market conditions change. In contrast,
with a forward or futures contract, a firm can adjust the hedging position or
roll over the contract as necessary.
• Complexity: Hedging with long-term currency options requires a certain
level of expertise and knowledge of financial markets. Smaller firms with
limited resources may find it challenging to navigate the complexities of
currency options and prefer to use simpler hedging techniques such as
forwards or futures.
• Strategic considerations: Some firms may choose not to hedge their
exchange rate risk using long-term currency options because they have a
strategic view on the direction of exchange rates and believe that they can
benefit from any movements in the exchange rate over the longer term. In
this case, they may prefer to take on the risk rather than pay the premium
for a long-term currency option.

4) The spot rate of the New Zealand dollar is $.70. A call option on New Zealand dollars with
a 1­year expiration date has an exercise price of $.71 and a pre­mium of $.02. A put option
on New Zealand dollars at the money with a 1­year expiration date has a premium of $.03.
You expect that the New Zealand dollar's spot rate will rise over time and will be $.75 in 1
year.
a. Today, Jarrod purchased call options on New Zealand dollars with a 1­year expiration
date. Estimate the profit or loss per unit for Jarrod at the end of 1 year. [Assume that the
options would be exercised on the expiration date or not at all.]
b. Today, Laurie sold put options on New Zealand dollars at the money with a 1­year
expiration date. Estimate the profit or loss per unit for Laurie at the end of 1 year. [Assume
that the options would be exercised on the expiration date or not at all.]
 a. Jarrod purchased call options on New Zealand dollars with an exercise price of $.71 and a
premium of $.02. If the spot rate is $.75 in 1 year, then the call option will be in-the-money
and Jarrod will choose to exercise the option.

The profit per unit for Jarrod can be calculated as follows:

Profit per unit = spot rate at expiration - exercise price - premium

Therefore, Jarrod's profit per unit at the end of 1 year would be $.02.

b. Laurie sold put options on New Zealand dollars at the money with a premium of $.03. If
the spot rate is $.75 in 1 year, then the put option will be out-of-the-money and the buyer
will not choose to exercise the option.

The profit per unit for Laurie can be calculated as follows:

Profit per unit = premium

Therefore, Laurie's profit per unit at the end of 1 year would be $.03. However, it's important
to note that selling options involves unlimited risk, since the buyer can potentially exercise
the option at any time before expiration. Therefore, Laurie's potential losses could be
significant if the spot rate of the New Zealand dollar were to fall below the exercise price.

5) You often take speculative positions in options on euros. One month ago, the spot rate of
the euro was $1.49, and the 1­month forward rate was $1.50. At that time, you sold call
options on euros at the money. The premium on that option was $.02. Today is when the
option will be exercised if it is feasible to do so.
a. Determine your profit or loss per unit on your option position if the spot rate of the euro
is $1.55 today.
b. Repeat question a, but assume that the spot rate of the euro today is $1.48.

a. The call option that was sold was at the money, which means that the exercise price of the
option was the same as the spot rate at the time the option was sold. Therefore, the exercise
price of the option was $1.49.

If the spot rate of the euro is $1.55 today, then the option buyer will choose to exercise the
option, since they can buy euros in the market for less than the exercise price. As the seller
of the call option, you would need to sell euros to the option buyer at the exercise price of
$1.49. However, since the current spot rate is higher than the exercise price, you would need
to purchase euros in the market at the current spot rate of $1.55 in order to fulfill your
obligation.

Profit or loss per unit = exercise price - premium + (spot rate at expiration - exercise price)
Profit or loss per unit = $1.49 - $.02 + ($1.55 - $1.49)
Profit or loss per unit = $0.09
Therefore, your profit per unit on the option position would be $0.09 if the spot rate of the
euro is $1.55 today.

b. If the spot rate of the euro is $1.48 today, then the option buyer will not choose to
exercise the option, since they can buy euros in the market for less than the exercise price.
As the seller of the call option, you would keep the premium of $.02 and would not need to
sell euros to the option buyer.

Profit or loss per unit = premium

Therefore, your profit per unit on the option position would be $.02 if the spot rate of the
euro is $1.48 today.