DDerivatives markets developed largely as tools to offset pre-existing price risk. In 1982, the Nasdaq PHLX (PHLX®) introduced currency options. Over the past four decades, trillions of notional exposures have been traded in US dollars (USD) against products linked to major foreign currencies.

The use case scenarios are varied, as are the end users. Multinational corporations based in the United States can use the products to manage foreign exchange risks related to foreign income. Investment banks, fund managers and other institutional users may seek to hedge the risk associated with foreign stocks or bonds. Both individual and institutional market participants could use these options to express an outlook or hedge risk on a specific foreign currency.

An example will help illustrate the potential benefit associated with foreign currency options settled in US dollars.

James and Mary are a retired couple living in a coastal town in the United States. They plan to buy a boat from a Mediterranean shipping company (MMC). The bill for the new vessel is €500,000. The funds are due in nine months.

The couple have set aside $492,500 based on the current USD to Euro exchange rate (0.985). Funds will remain in an interest-bearing account until the final invoice is due in 270 days. Interest on the funds will bring the account value to $510,000 in nine months.

Final payment must be made in euros, so their risk over the next nine months is tied to the strength of the euro against the US dollar.

Source: Live Flight Pro

Over the past 10 years, the USD/EUR cross has oscillated between (0.975 and 1.38). The currency spot rate changes during the day, as does the value of stocks or commodities. If, for example, the cross rate returned to 1.10 when the bill was due, the couple would need $550,000 to pay for the boat.

Today it takes $0.985 to buy €1, but in the first quarter of 2014 it took $1.38 to buy €1. Foreign exchange markets have become more volatile in recent years. Central banks around the world have turned to less accommodative monetary policies. Interest rates have risen in the United States and elsewhere, which correlates with currency volatility.

What if the USD continues to strengthen against the EUR and the pair falls to 0.85? In this situation, they would benefit because it would only take ($500,000 * 0.85) = $425,000 to complete the trade.

To offset their currency risk, James and Mary decide to use Nasdaq currency options. There are multiple expirations and strikes/sets of options, so they can customize their risk compensation. The couple wants to minimize their premium expense on the foreign exchange transaction.

Interest earned on the funds will total approximately $17,500 when the bill is due. They are ready to use this money to establish a hedge.

As a result, they decide to sell 100 XDE 102.50 nine-month put options at 2.75 each. They are also selling 100 nine-month XDE 0.95 Strike Calls at 2.00 each. The total amount of premiums is $7,500. Options expire at noon EST on the third Friday of the expiration month.

The long call option and the short put option on XDE both benefit from the strength of the Euro against the USD. As such, the option position is used as a hedge against an unfavorable currency movement for James and Mary.

What-if scenarios:

USD/EUR cash settlement at 0.985 (unchanged from today).

Implications (Hedge is a cost):

• The coverage would lose the $7,500 premium paid.
• James and Mary will need ($500,000 * 0.985) US$492,500 to complete the transaction.
• They have $510,000 in the account due to earned interest.
• Net of hedging, they are left with ($510,000 – $492,500 – $7,500) $10,000 in savings after the purchase.

USD/EUR spot settlement at 0.940 (the euro is weaker against the USD).

Implications (a stronger dollar is a benefit; a hedge is a cost):

• The 95.00 short put options are worth $100 each ($10,000 total). Calls expire OTM (no value). The hedge is down $10,000 plus the premium paid to enter the position ($7,500). They lose $17,500 on the cover.
• James and Mary will need ($500,000 * 0.940) $470,000 to complete the transaction.
• They have $510,000 in the account due to earned interest.
• Net of the hedge, they are left with ($510,000 – $470,000 – $17,500) $22,500 in savings after purchase.

Spot settlement USD/EUR @ 1.05 (Euro is stronger against USD).

Implications (lower dollar is a cost; coverage is a benefit):

• The long 102.50 strike calls are worth $250 each ($25,000 total). Short puts expire OTM (worthless). The hedge returns ($25,000 – 7,500) $17,500.
• James and Mary will need ($500,000 * 1.05) $525,000 to complete the transaction.
• They have $510,000 in the account due to earned interest.
• Net of the hedge, they are left with ($510,000 + $17,500 – $525,000) $2,500 in savings after the purchase.

USD/EUR spot settlement at 1.15 (the euro is significantly stronger against the USD).

Implications (lower dollar is a big cost; coverage is a big benefit):

• The long 102.50 strike calls are worth $1,250 each ($125,000 total). Short puts expire OTM (worthless). The hedge yields ($125,000 – $7,500) $117,500.
• James and Mary will need ($500,000 * 1.15) $575,000 to complete the transaction.
• They have $510,000 in the account due to earned interest.
• Net of the hedge, they are left with ($510,000 + $117,500 – $575,000) $52,500 in savings after the purchase.

USD/EUR cash settlement at 0.85 (the dollar is significantly stronger than the euro).

Implications (a stronger dollar is a big benefit, hedging is a big cost):

• The 0.95 short put options are worth $1,000 each (down from $100,000). Short calls expire OTM (worthless). The coverage is equivalent to a loss of ($100,000 + $7,500) ($107,500).
• James and Mary will need ($500,000 * 0.85) $425,000 to complete the transaction.
• They have $510,000 in the account due to earned interest.
• Net of the hurdle, they need ($510,000-$425,000-$107,500) another $22,500 to cover the cost of the boat and the hurdle.

The couple understand their alternatives. They know the historical range of the USD against the Euro. They consider the probability of a much weaker Euro (significantly stronger USD) to be low. They are mostly concerned about the potential for dollar weakness which, in the absence of a hedge, would make their trade more expensive.

Currency options can be used in different ways. We have highlighted a use case for a future transaction in a foreign currency. For more information visit this page.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The following is an excerpt from a recent edition of Bitcoin Magazine Pro, Bitcoin magazine premium markets newsletter. To be among the first to receive this information and other on-chain bitcoin market analysis straight to your inbox, Subscribe now.

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