Call options

Factors affecting Currency Call Option Premium

The premium on a call option represents the cost of having the right to buy the underlying
currency at a specified price. For MNCs that use currency call options to hedge, the premium
reflects a cost of insurance or protection to the MNCs.
The call option premium (referred to as C) is primarily influenced by three factors:
C + f(S – X, T, σ)
Where S – X represents the difference between the spot exchange rate (S) and the strike or
exercise price (X), T represents the time to maturity, and σ represents the volatility of the
currency, as measured by the standard deviation of the movements in the currency.

 Spot price relative to Strike Price. The higher the spot rate relative to the strike price, the
higher the option price will be. This is due to the higher probability of buying the
currency at a substantially lower rate than what you could sell it for. This relationship can
be verified by comparing premiums of options for a specified currency and expiration
date that have different strike prices.
 Length of Time Before the Expiration Date. It is generally expected that the spot rate has
a greater chance of rising high above the strike price if it has a longer period of time to
do so. A settlement date in June allows two additional months beyond April for the spot
rate to move above the strike price. This explains why June option prices exceed April
option prices given a specific strike price. This relationship can be verified by comparing
premiums of options for a specified currency and strike prices that have different
expiration dates.
 Potential Variability of Currency. The greater the variability of the currency, the higher
the probability that the spot rate can rise above the strike price. Thus, less volatile
currencies have lower call option prices. For example, the Canadian dollar is more stable
than most other currencies. If all other factors are similar, Canadian call options should
be less expensive than call options on other foreign currencies.

How Firms Use Currency Call Options

Example 1 – Using Call Options to Hedge Payables

When Pike Co. of Seattle orders Australian goods, it makes a payment in Australian dollars to the
Australian exporter upon delivery. An Australian dollar call option locks in a maximum rate at which Pike
can exchange dollars for Australian dollars. This exchange of currencies at the specified strike price on
the call option contract can be executed at any time before the expiration date. In essence, the call
option contract specifies the maximum price that Pike must pay to obtain these Australian imports. If the
Australian dollar’s value remains below the strike price, Pike can purchase Australian dollars at the
prevailing spot rate when it needs to pay for its imports and simply lets its call option expire.
Example 2 – Using Call Options to Hedge Project Bidding

Kelly Co. is an MNC based in Fort Lauderdale that has bid on a project sponsored by the Canadian
government. If the bid is accepted, Kelly will need approximately C$500,000 to purchase Canadian
materials and services. However, Kelly will not know whether the bid is accepted until 3 months from
now. In this case, it can purchase call options with a 3-month expiration date. Ten call-option contracts
will cover the entire amount of potential exposure. If the bid is accepted, Kelly can use the options to
purchase the Canadian dollars needed. If the Canadian dollar has depreciated over time, Kelly will likely
let the option expire.

Assume that the exercise price on Canadian dollars is $0.70 and the call option premium is $0.02 per
unit. Kelly will pay $1,000 per option (since there are 50,000 units per Canadian dollar option), or
$10,000 for the 10 contracts. With the options, the maximum amount necessary to purchase the
C$5000,000 is $350,000 (computed as $0.70 per Canadian dollar x C$500,000). The amount of US dollars
needed would be less if the Canadian dollar’s spot rate were below the exercise price at the time the
Canadian dollars were purchased.

Even if Kelly’s bid is rejected, it will exercise the currency call option if the Canadian dollar’s spot rate
exceeds the exercise price before the option expires and would then sell the Canadian dollars in the spot
market. Any gain from exercising may partially or even fully offset the premium paid for the options.

Example 3 – Using Call Options to Hedge Target Bidding

Morrison Co. is attempting to acquire a French firm and has submitted its bid in euros. Morrison has
purchased call options on the euro because it will need euros to purchase the French company’s stock.
The call options hedge the US firm against the potential appreciation of the euro by the time the
acquisition occurs. If the acquisition does not occur and the spot rate of the euro remains below the
strike price, Morrison Co. can let the call options expire. If the acquisition does not occur and the spot
rate of the euro exceeds the strike price, Morrison Co can exercise the options and sell the euros in the
spot market. Alternatively, Morrison Co. can sell the call options it is holding. Either of these actions may
offset part or all of the premium paid.
Example 4 – Speculating with Currency Call Options

Jim is a speculator who buys a British pound call option with a strike price of $1,40 and a December
settlement date. The current spot price as of that date is about $1.39. Jim pays a premium of $0.12 per
unit for the call option. Assume there are no brokerage fees. Just before the expiration date, the spot
rate of the British pound reaches $1.41. At this time, Jim exercises the call option and then immediately
sells the pounds at the spot rate to a bank. To determine Jim’s profit or loss, first compute his revenues
from selling the currency. Then subtract from this amount the purchase price of pounds when exercising
the option, and also subtract the purchase price of the option. The computations follow. Assume one
option contract specifies 31,250 units.

PER UNIT PER CONTRACT

Selling price of £ $1.41 $44,063 ($1.41 x 31,250 units)
- Purchase price of £ -1.4 -43,750 ($1.40 x 31,250 units)
- Premium paid for option -0.012 -375 ($0.012 x 31,250 units)
= Net profit -$0.002 -$62 (-$0.002 x 31,250 units)

Assume that Linda was the seller of the call option purchased by Jim. Also assume that Linda would
purchase British pounds only if and when the option was exercised, at which time she must provide the
pounds at the exercise price of $1.40. Using the information in this example, Linda’s net profit from
selling the call option is derived here:

PER UNIT PER CONTRACT

Selling price of £ $1.40 $43,750 ($1.40 x 31,250 units)
- Purchase price of £ -1.41 -44,063 ($1.41 x 31,250 units)
+ Premium received 0.012 +375 ($0.012 x 31,250 units)
= Net profit $0.002 $62 ($0.002 x 31,250 units)

As a second example, assume the following information:

 Call option premium on Canadian dollars (C$) = $0.01 per unit

 Strike price = $0.70
 One Canadian dollar option contract represents C$50,000

A speculator who had purchased this call option decided to exercise the option shortly before the
expiration date, when the spot rate reached $.74. The speculator immediately sold the Canadian dollars
in the spot market. Given this information, the net profit to the speculator is computed as follows:

PER UNIT PER CONTRACT

Selling price of £ $0.74 $37,000 ($0.74 x 50,000 units)
- Purchase price of £ -0.70 -35,000 ($0.70 x 50,000 units)
- Premium paid for
option -0.01 -500 ($0.01 x 50,000 units)
= Net profit $0.03 $1,500 ($0.03 x 50,000 units)
If the seller of the call option did not obtain Canadian dollars until the option was about to be exercised,
the net profit to the seller of the call option was:

PER UNIT PER CONTRACT

Selling price of £ $0.70 $35,000 ($0.70 x 50,000 units)
- Purchase price of £ -0.74 -37,000 ($0.74 x 50,000 units)
- Premium paid for
option 0.01 +500 ($0.01 x 50,000 units)
= Net profit -$0.03 -$1,500 (-$0.03 x 50,000 units)

Note: When brokerage fees are ignored, the currency call purchaser’s gain will be the seller’s loss. The
currency call purchaser’s expenses represent the seller’s revenues, and the purchaser’s revenues
represent the seller’s expenses. Yet, because it is possible for purchasers and sellers of options to close
out their positions, the relationship described here will not hold unless both parties begin and close out
their positions at the same time.

An owner of a currency option may simply sell the option to someone else before the expiration date
rather than exercising it. The owner can still earn profits since the option premium changes over time,
reflecting the probability that the option can be exercised and the potential profit from exercising it.

Example 5 – Break-even Point from Speculation

Based on the information from example 4, the strike price is $0.70 and the option premium is $0.01.
Thus for the purchaser to break-even, the post rate existing at the time the call is exercised must be
$0.71 ($0.70 + $0.01). Of course, speculators will not purchase a call option if they think the spot rate
will only reach the break-even point and not go higher before the expiration date. Nevertheless, the
computation of the break-even point is useful for a speculator deciding whether to purchase a currency
call option.

Note: The purchaser of a call option will break even if the revenue from selling the currency equals the
payments for (1) the currency (at the strike price) and (2) the option premium. In other words, regardless
of the number of units in a contract, a purchase will break even if the spot rate at which the currency is
sold is equal to the strike price plus the option premium.