Page 132 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 8: Currency Futures and Currency Options

According to the agreement, IFC would provide loans to Indian companies in local currency Notes
without their being exposed to foreign exchange risk. The facility is expected to be
particularly useful in IFC’s efforts to extend local currency financing for the infrastructure
as well as for the general manufacturing sector.
This offering would complement IFC’s other rupee financing products, which include
partial guarantees and structural finance products. With annual business volume of about
$400 million, India has emerged as the largest recipe of IFC financing in the financial year
ended 2001. IFC’s initiatives in local currency financing are expected to sustain further
growth in the size and diversity of its business in India.
Source: International Financial Management, Madhu Vij, Excel Books.

8.5 Fundamentals of Currency Options

Options are derivative securities that are derived from some underlying assets (stock, index,
currency interest rate, commodity) and their prices depend critically on the spot values of those
assets.
An option is a ‘wasting asset’; that is, it has only an initial value that declines (or “wastes” away)
as time passes – it may even expire worthless. The holder has the option, to exercise it or sell it,
in the listed options market before the expiration date.
Options trading (sans transaction costs) represents a zero sum game, i.e., any profits (losses)
experienced by option buyer are offset by losses (profits) experienced by option writers while
options trading (transaction costs included) must be a less than zero sum game. Either way
(transaction included or not) options trading may result in utility gains through transfer of risk
between market players.

8.5.1 Option Instruments

Basically there are two types of option instruments:

(i) Call Option
(ii) Put Option
The person selling an option in the market is known as option writer and the person buying the
option is called option holder.
Call Option

A call option gives its owner the right to buy stock at a specified exercise or striking price. In
some cases, the option can be exercised only on one particular day and it is then conventionally
known as a European call; in other cases it can be exercised on or before that day and it is then
known as an American call. The diagram below shows the change in the value of a call option on
a stock with an exercise price of ` 100 on TISCO’s stock. If the stock price at the time of exercise
is less than ` 100, nobody will exercise the call option and the call option will be worthless. On
the other hand, if the share price turns out to be greater than ` 100, it will pay us to exercise our
call option to buy the share. In this case the option will be worth the market price of share minus
` 100, that we must pay to acquire it.
If TISCO’s stock price falls to ` 80, the call option will be worthless, but if the price rises to ` 125,
the option will be worth 125 – 100 = ` 25. The possible pay-offs to the option are therefore:

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