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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
Value
0 St+n
Zt,t+n
Value
0 St+n
X
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
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