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Derivatives

Session 5

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Foreign Currency Derivatives

Financial management of the MNE in the 21st century involvesfinancial derivatives.

These derivatives, so named because their values are derivedfrom underlying assets, are a powerful tool used in business

today.

These instruments can be used for two very distinctmanagement objectives:

Speculation use of derivative instruments to take a position in the

expectation of a profit

Hedging use of derivative instruments to reduce the risks associatedwith the everyday management of corporate cash flow

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The Nature of Derivatives

A derivative is an instrument whose value

depends on the values of other more basic

underlying variables called bases (underlying

asset, index, or reference rate), in acontractual manner

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The Nature of Derivatives

The underlying asset can be equity, forex,commodity or any other asset.

For example, wheat farmers may wish to sell

their harvest at a future date to eliminate therisk of a change in prices by that date. Such

a transaction is an example of a derivative.The price of this derivative is driven by the

spot price of wheat which is the underlying.

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Examples of Derivatives

Forward Contracts

Futures Contracts

Swaps Options

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The Players in a Derivative Market

The following three broad categories of participants

Hedgers

Speculators

Arbitrageurs

Some of the large trading losses in derivatives occurred

because individuals who had a mandate to hedge

risks switched to being speculators

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Why are they used?

To discover price

To hedge risks

To speculate (take a view on the future direction of

the market)

To lock in an arbitrage profit

To change the nature of a liability

To change the nature of an investment withoutincurring the costs of selling one portfolio and buying

another

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Derivatives in India

In the Indian context the Securities Contracts(Regulation) Act, 1956 (SC(R)A) defines

derivative to include

1. A security derived from a debt instrument, share,loan whether secured or unsecured, risk instrumentor contract for differences or any other form ofsecurity.

2. A contract which derives its value from the prices, orindex of prices, of underlying securities.

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Derivatives in India

Derivatives are securities under the SC(R)A

and hence the trading of derivatives is

governed by the regulatory framework under

the SC(R)A.

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Currency Forwards

A forward contract is an agreement between afirm and a commercial bank to exchange aspecified amount of a currency at a specified

exchange rate (called the forward rate) on aspecified date in the future.

Forward contracts are often valued at $1million or more, and are not normally used byconsumers or small firms.

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Currency Forwards

When MNCs anticipate a future need for or future

receipt of a foreign currency, they can set up forward

contracts to lock in the exchange rate.

The % by which the forward rate (F) exceeds thespot rate (S) at a given point in time is called the

forward premium (p).

F= S (1 +p)

Fexhibits a discount whenp < 0.

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Currency Forwards

Example S = $1.681/, 90-day F= $1.677/

annualizedp =FS 360S n

=1.677 1.681 360 =.95%

1.681 90

The forward premium (discount) usually reflects the

difference between the home and foreign interestrates, thus preventing arbitrage.

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Foreign Currency Futures

Aforeign currency futures contractis an alternativeto a forward contract that calls for future delivery ofa standard amount of foreign exchange at a fixedtime, place and price.

It is similar to futures contracts that exist forcommodities such as cattle, lumber, interest-bearingdeposits, gold, etc.

In the US, the most important market for foreigncurrency futures is the International MonetaryMarket (IMM), a division of the Chicago MercantileExchange.

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Currency Forwards

A swap transaction involves a spot transaction along

with a corresponding forward contract that will

reverse the spot transaction.

A non-deliverable forward contract (NDF) does notresult in an actual exchange of currencies. Instead,

one party makes a net payment to the other based

on a market exchange rate on the day of settlement.

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An NDF can effectively hedge future

foreign currency payments or receipts:

Forward Market

Expect need for 100MChilean pesos.Negotiate an NDF to buy

100M Chilean pesos onJul 1. Reference index(closing rate quoted byChiles central bank) =$.0020/peso.

April 1

Buy 100M Chileanpesos from market.

July 1

Index = $.0023/peso receive $30,000 frombank due to NDF.

Index = $.0018/peso pay $20,000 to bank.

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Currency Futures

Currency futures contracts specify a standardvolume of a particular currency to beexchanged on a specific settlement date.

They are used by MNCs to hedge theircurrency positions, and by speculators whohope to capitalize on their expectations ofexchange rate movements.

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Currency Futures

The contracts can be traded by firms or individuals

through brokers on the trading floor of an exchange

(e.g. Chicago Mercantile Exchange), automated

trading systems (e.g. GLOBEX), or the over-the-counter market.

Brokers who fulfill orders to buy or sell futures

contracts typically charge a commission.

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Foreign Currency Futures

Contract specifications are established by the exchange onwhich futures are traded.

Major features that are standardized are:

Contract size

Method of stating exchange rates

Maturity date

Last trading day

Collateral and maintenance margins

Settlement

Commissions

Use of a clearinghouse as a counterparty

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Foreign Currency Futures

Foreign currency futures contracts differ from forwardcontracts in a number of important ways:

Futures are standardized in terms of size while forwards can becustomized

Futures have fixed maturities while forwards can have anymaturity (both typically have maturities of one year or less)

Trading on futures occurs on organized exchanges whileforwards are traded between individuals and banks

Futures have an initial margin that is market to market on a daily

basis while only a bank relationship is needed for a forward Futures are rarely delivered upon (settled) while forwards are

normally delivered upon (settled)

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Delivery date Customized Standardized

Participants Banks, brokers, Banks, brokers,MNCs. Public MNCs. Qualified

speculation not public speculationencouraged. encouraged.

Security Compensating Small security

deposit bank balances or deposit required.credit lines needed.

Clearing Handled by Handled byoperation individual banks exchange

& brokers. clearinghouse.

Daily settlementsto market rices.

ompar son o e orwar u uresMarkets

Forward Markets Futures Markets

Contract size Customized Standardized

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An Option is.

A contract where the buyer has the right, but not theobligation to

- Buy/Sell- Specified quantity of a currency

- At a specified price (strike price)- By a particular date (expiry date)

For this right, the buyer pays the seller(writer) of theoption an upfront fee (called option premium)

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Forwards Options Forwards most common & and popular derivative

instrument for hedging forex exposures.

Offers best protection against adverse exchangerate movements BUT carries risk of opportunity lossin the event of favorable movements.

An Option offers the protection of a forward contractbut without its commitment.

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Options v/s Forwards

Options give the buyer aright but no obligation.

Good instrument to hedge

adverse price moves &avoiding opportunity loss.

Upfront premium

Can choose the strikeprice

Forwards are fixed pricecontracts wherein thebuyer/seller is obligated tothe price

Opportunity loss

No upfront premium

Cannot choose the price

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Option Terminologies

Cal l Opt ion:

Gives the holder the right but not the obligation to BUY an

underlying at a fixed price from the writer of the option.

Put Opt ion :

Gives the holder the right but not the obligation to SELL

an underlying at a fixed price to the writer of the option

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Two types of option

American Option

May be exercised at any time during the life of a contract.

European Option.

May be exercised only at maturity or expiry date.

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Options - specif ications

Strike Price or Exercise priceThe fixed price at which the option holder has theright to buy or sell the underlying currency.

Expiry DateThe last day on which the option may be exercised.

Life or Exercise Period

The period of time during which the option holderenjoys the purchased option contracts.

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Advantage of Option over Forwards

Forward Contract

On April 01, importer A buys USD forward at 43.75 with anexpiry date May 31.

Currency Option

Same day, importer B buys a USD call option, with a strike

price of 44.00 at same expiry on 31st May and pays apremium of 15 paisa. His worst effective rate is now 44.15.

On May 31

USD/INR trades at 43.50. Importer A buys Dollars at 43.75.Importer B can ignore the option and buy USD at thecurrent market rate of 43.50.

His net cost now works out to 43.50+0.15 = 43.65.

O ti l

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Options example USD imports - due 31st May

Company buys an USD call option with a strike price of43.70 when spot rate is 43.60.

2 business days before the expiry date, the company has to

decide whether or not to exercise the option.

So on 29th May at the specified cut-off time, if spot USD isover 43.70, the company will exercise the option and buyUSD at 43.70

However, if spot rate is less than 43.70, then the companycan let the option lapse and instead fix the spot rate for thetransaction on 29th May.

O ti l

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Options example USD exports - due 31st May

Company buys an USD put option with a strike price of43.70 when spot rate is 43.60.

2 business days before the expiry date, the company has to

decide whether or not exercise the option.

So on 29th May at the specified cut-off time, if spot USD isbelow 43.70, the company will exercise the option and SellUSD at 43.70

However, if spot rate is morethan 43.70, then the companycan let the option lapse and instead fix the spot rate for thetransaction on 29th May.

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Risk / Prof i t Prof i le

Buyer Seller

Profit Unlimited Premium

Risk Premium Unlimited

O i ik i

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Option str ike pr iceIn the money (ITM) The option is In the Money when the Strike Price is

favourable to the option holder(buyer) than the currentforward rate.

Eg: USD put option with strike 43.80 current fwd rate 43.75option in the money

Out of the money (OTM) The option is Out of the Money when the Strike Price is

unfavourable to the option holder(/buyer) than the currentforward rate.

Eg: USD call option with strike 43.90 current fwd rate 43.75

option out of the moneyAt the money (ATM) The option is At the Money when the Strike Price is equal to

the current forward rate.

O ti F d & O P iti

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Option, Forwards & Open Position

A call option will outperform a forward contract when spot

rate at maturity plus option premium is less than theforward rate.

A put option will outperform a forward contract when spotrate at maturity less the option premium is greater than

the forward rate.

As to unhedged positions, a call option will be better thanan unhedged position only if the strike price plus premiumis less than the spot at maturity.

Likewise, a put option will be better than an unhedgedposition only if the strike price less the option premium isgreater than the spot at maturity.

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Price of an Option

Can the Option buyer have the cake & eat it too?

Not really - since the option seller charges the buyer an

upfront premium payable in cash.

And the upfront premium can be as high as 1% or even moredepending on the strike price and the maturity period.

Wh O ti P i ?

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Why Option Premium?

An option buyer never loses money with reference to thestrike price but may make or save money.

The option seller is in an opposite position he can havewindfall losses.

Based on the probability distribution of spot prices at

maturity, there is an expected gain or profit to the buyer.

This is charged as upfront premium.

Option seller always incurs a loss, while he hedges his

short option position using mathematical hedgingtechniques

The loss is recovered by way of the upfront premium.

O ti i Q t ti

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Option premium - Quotations

Points of the second currency/terms currency

or

Premiums are quoted as a flat percentage of the basecurrency Principal amount

Example:USD/INR put 1m $USD/INR strike price = 43.90Premium quoted as 0.33 INR

Or 0.33*1,000,000 = 3,30,000 INR330,000 INR = 7,569 $ (330,000/43.60 spot)7,569 $ is 0.75% of 1m $ principal

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Factors determining Premium value

Volatility

Strike Price

Life or Exercise Period

Interest Rates - domestic & foreign

Current Market Rate

V l tilit hi t i / i l i d

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Volatilityhistor ic v/s implied Volatility is defined as the standard deviation over the

mean on the returns on prices.

Historic volatility is the volatility calculated using a set ofhistorical data (usually the set of data corresponds to theperiod of the option).

Implied volatility is the market expectation of futurevolatility.

Traders in the option market quote the option premium,which is then used as an input in the Black & Scholesoption pricing formula to calculate the implied volatility.

Research has proved that option trading affects thevolatility of the underlying market, causing a reduction inmost cases.

Change in premium with change in volati l i ty

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0

0.005

0.01

0.015

0.02

0.025

1 2 3 4 5 6 7 8 9 10

X axis - Volatility in %

Y axis - Option Premium

s

Change in premium with change in volati l i ty

St ik P i D i

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Str ike Price Dynamics

The option premium can be quite high for ATM options.

Is there a way to reduce the premium ?

There is one golden rule. You cant get anything in themarket for free.

So to reduce the premium, you have to give up someprotection.

To reduce the premium, you have to raise the strike priceand consider buying an OTM option thereby giving up

some protection. The more OTM the option is, the lowerwill be the premium. Conversely, the more ITM an optionis, the higher will be the premium.

St ik P i

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Str ike Pr ice

The more otm the option is, the lower will be the

premium. Conversely, the more itm an option is, thehigher will be the premium. For eg: USD/INR Spot =43.50

It is seen that the reduction in premium is less than theprotection sacrificed.

Strike Price Premium Fall in Protection

Premium Sacrificed

43.90 0.450

43.80 0.400 0.050 0.10

43.70 0.354 0.046 0.10

43.60 0.311 0.043 0.10

43.50 0.273 0.038 0.10

6 month Dollar Put

Choosing the r ight str ike pr ice

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USD/INR spot = 43.50; 6 months ATM = 43.86

Worst case rate = 43.35

You have USD exports

Fix the worst case rate (WCR)

Bearish on Rupee

You buy an OTM Put with lowest strike so that the strike minuspremium is above WCR

Strike = 43.70 Premium = 0.35 WCR = Strike - Premium = 43.35

Bullish on Rupee

You buy ATM USD Put

Strike = 43.86 Premium = 0.41, WCR= Strike - Premium = 43.45,which is more than 43.35 (WCR)

Choosing the r ight str ike pr ice

Comparison between Str ike Price & WCR Pay off Profi le

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43.2000

43.3000

43.4000

43.5000

43.6000

43.7000

Strike 43.70

Strike 43.86

Strike 43.70 43.35 43.35 43.51 43.67

Strike 43.86 43.45 43.45 43.45 43.61

43.54 43.70 43.86 44.02

Strike 43.70 --> premium 0. 35 --> WCR 43.35 --> If bearish on Rupee.

Strike 43.86 --> premium 0.41--> WCR 43.45 --> If bullish on Rupee.

X axis - Spot at maturityY axis - Effective rate

Comparison between Str ike Price & WCR Pay off Profi le

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Option Strategies

Long USD Call Option

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Long USD Call Option

Profit

LossArea

Loss

Cost of Premium

Strike Price

Break-even price

ProfitUnlimited

Price of underlying(USD/INR)43.90

43.90+0.45= 44.35

Short USD Call Option

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Short USD Call Option

Strike Price

Break-evenprice

Price of underlyingUSD/INR

LossUnlimited

PremiumIncome orProfit

Profit

Loss

43.90

43.90+0.45= 44.35

Long USD Put Option

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Long USD Put Option

Strike Price

Break-evenprice

Price of underlyingUSD/INR

Profitunlimited

Loss

Cost ofPremium

43.90 - 0.45= 43.45

43.90

Short USD Put Option

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Short USD Put Option

Strike Price

Break-evenprice

Price of underlying

Profit

Loss

PremiumIncome orProfit

LossUnlimited

43.90

43.90 - 0.45= 43.45

I ndian Scenar io

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I ndian Scenar io

In the pre-liberalization era, the insular economicenvironment felt no scope for the derivative market todevelop.

Indian corporate depended on term lending institutions fortheir project financing & commercial banks for working

Capital. Forward contract was the only derivative product to hedge

financial risk.

Post-liberalization India saw developments in the

instrument forward contract.

Corporate was allowed to cancel & rebook forwardcontracts.

Why Rupee options?

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Why Rupee options?

Rupee options would enable an Indian corporate to hedge

against downside risk on FC/INR while retaining the upside,by paying a premium upfront better competitiveness.

Hedge against uncertainty of cash flows due to NONLINEAR payoff of option for eg. Indian company bidding

for an international contract bid quote in Dollars but cost inRupees Risk of USD/INR falling till the contract is awarded forwards will bind the company even if the overseascontract not allotted Option contract will freeze the liabilityonly to the option premium paid upfront.

Attract more forex investment due to availability of anothermechanism for hedging forex risk.

R ti h ?

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Rupee options why now?

RBIs earlier concerns

Poor risk management skills at banks, who would beselling options to customers

Options market may impact the spot rupee

Current considerations Increasing volatility in the rupee makes it difficult for

corporates to manage risk Exchange rate policy appears looser; strong reserves

provides comfort Option use is getting more commonplace

Iss es in pricing

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Issues in pricing

Different banks will use different pricing models, although

FEDAI is already polling banks for implied volatility, whichwill be available on their web-site

Spread between theoretical price and quoted price can bequite high

Need to shop around

Your Portfolio

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Your Portfolio

USD/INR Spot 43.50

6 month fwd rate 43.86

You are an importer

Worst Case Rate (WCR) 44.40

6 month USD/INR volatility 3% / 3.5%

Diff based on Risk free rate 1.65%

Low Cost Option Strategies

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Low Cost Option Strategies

An option buyer can reduce his premium cost by selling

another option. The combination can reduce the cost asthe premium received on the option sold could eitherpartially or fully offset the cost of option bought.

Different Strategies:

1. Range Forward

2. Participating Forward

3. Seagull

4. Leveraged forward

Zero Cost Range Forward (RF)

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Zero Cost Range Forward (RF)

Range Forward - involves buying an out of the money

call/put option with the worst case rate as the strike priceand selling an out of the money put/call option with such astrike price (best case rate) that the net premium is zero

If price at maturity is beyond the wcr the bought option will

be exercised

If the price at maturity is beyond bcr the sold option will beexercised

If price at maturity is between the wcr & bcr you buy orsell at spot

Although entry is painless, exit could be painful

Range Forward

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g

43.00

43.20

43.40

43.60

43.80

44.00

44.20

44.40

44.60

43.00

43.10

43.20

43.30

43.40

43.50

43.60

43.70

43.80

43.90

44.00

44.10

44.20

44.30

44.40

44.50

44.60

44.70

44.80

spot at maturity

NeteffectiveRate

Buy USD Call at 44.40, Sell USD Put at 43.50

Participating Forward (PF)

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Participating Forward (PF)

Participating forward - involves buying an out of themoney call/ put option with the worst case rate as thestrike price and selling an in the money put/call option fora reduced amount and with the same strike price so thatthe net premium is zero

In effect there is a synthetic OTM forward contract for theamount of the ITM option sold and a free OTM option for

the balance amount

Participating Forward

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g

42.60

42.80

43.00

43.20

43.40

43.60

43.80

44.00

44.20

44.40

44.60

42.70

42.90

43.10

43.30

43.50

43.70

43.90

44.10

44.30

44.50

44.70

Spot at Maturity

NetE

ffective

rate

Buy USD Call at 44.40, Sell USD Put at 44.40 for 31% of Call amount

Seagull (S)

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Seagull (S) Involves buying an out of the money call/put option (A) and selling an

out of the money put/call option (B) & also selling a far-of-the-moneycall/put option (C ) so that the net premium of the whole portfolio iszero

If price at maturity is between the strikes of (A) and (C), only (A) willbe exercised

If the price at maturity is beyond the strike of (B), only (B) will be

exercised

If the price at maturity is beyond the strike of (C), both (A) and (C) willbe exercised.

If price at maturity is between the strikes of (A) & (B) you buy or sell at

spot

This a a variant of the range forward as a far-out-of-the-money call/putis sold with the range forward to improve the best case rate or thestrike of (B).

Seagull

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g

42.5

43

43.5

44

44.5

45

42.70

42.90

43.10

43.30

43.50

43.70

43.90

44.10

44.30

44.50

44.70

44.90

45.10

Spot at Maturity

NetE

ffectiverate

Buy USD Call at 44.40, Sell USD Put at 43.25, Sell USD Call at 44.80

Leveraged Forward (PF)

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Leveraged Forward (PF)

Leveraged forward - involves buying an in the money call/put option and selling an out of the money put/call optionfor an increased amount and with the same strike price sothat the net premium is zero

In effect there is a synthetic in the money forward contractfor the full amt with a leveraged loss beyond the syntheticITM forward rate (strike price).

Leveraged Forward

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43.20

43.40

43.60

43.80

44.00

44.20

44.40

43.00

43.10

43.20

43.30

43.40

43.50

43.60

43.70

43.80

43.90

44.00

44.10

44.20

44.30

44.40

44.50

Spot at Maturity

NetE

ffectiveRate

Buy USD Call at 43.65, Sell USD Put at 43.65 for 200% of Call amount

Rupee Options Product specif ications

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Rupee OptionsProduct specif ications

Vanilla European options & combinations thereof at

introduction. This will continue till banks havesophisticated systems & risk management frameworks tohedge this new non-linear product.

Over the counter contracts.

Can be tailored to suit the corporates need.

FC-INR where foreign currency may be the ccy desiredby the corporate.

No minimum amt recommended by RBI.

Premium payable on spot basis.

Rupee Options Product specif ications..

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Rupee Options Product specif ications..

Settlement would be either by delivery on spot basis or

net cash settlement in Rupees on Spot basis, dependingon the FC-INR spot rate on maturity date. (specs will bespecified in the contract) RBI reference rate could be thereference rate for settlement.

Strike Price & Maturity could be tailored to suitcounterparties needs typical maturities are 1 week,2weeks, 1, 2, 3, 6, 9 & 12 months.

Exercise style: European.

Uses of Rupee options

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Uses of Rupee options

To hedge genuine FX exposures arising out of

trade/business (Banks may book transactions based onestimated exposure for uncertain amounts)

To hedge FC loans.

To hedge GDR after the issue price is finalised. Balance in EEFC accounts.

Special cases & contingent exposures.

Derived FX exposure viz FX exposure generated due to aasset/liability coupon &/or P+I swap.

One hedge for one exposure

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One hedge for one exposure

Only one hedge may be booked against a particularexposure for a given time period.

For eg Exporter with USD receivables after 6 months,

can sell a forward for 3 month & after 3 month square theforward & book an option for another 3 months.

But the exporter cannot book a forward & an option forthe same exposure at the same time.

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Hedging Rupee Options

Authorized dealers to be allowed to hedgeoptions by accessing the spot market.

Extent & frequency to be decided bydealers.

ADs to be allowed to hedge Greeks usingoptions.

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Clients as net receivers of premium

Earlier clients could not receive netpremium.

Now large corporates with aggressivetreasury operations have been allowed toreceive net premium as the market

matures. They can buy as well sell option contracts.

Barr ier options

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Barr ier options

These are two types of barriers in options:- Knock in barrier

- Knock out barrier

These can be single barrier or double barrieroptions

Barriers are American in nature

Main advantage is smaller upfront premiumcompared to Plain Vanilla option with same strike

price

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Barrier Options

A barrier option, also known as knock out option, isa type of financial option where the option toexercise depends on the underlying crossing orreaching a given barrier level.

Barrier options were created to provide theinsurance value of an option without charging asmuch premium.

For example, if you believe that US Dollar will go upthis year, but are willing to bet that it won't go above

Rs45, then you can buy the barrier and pay lesspremium than the vanilla option.

http://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Option_%28finance%29

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Barrier Options

Barrier options are path-dependent exotics that aresimilar in some ways to ordinary options.

There are put and call, as well as European and

American varieties. But they become activated or, on the contrary, null

and void only if the underlying reaches a

predetermined level (barrier).

http://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/wiki/Exotic_derivatives

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In and Out

"In" options start their lives worthless and onlybecome active in the event a predetermined knock-in barrier price is breached.

"Out" options start their lives active and become null

and void in the event a certain knock-out barrierprice is breached.

In either case, if the option expires inactive, thenthere may be a cash rebate paid out.

This could be nothing, in which case the option endsup worthless, or it could be some fraction of thepremium.

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Four main types of barrier options

Up-and-out: spot price starts below the barrier level and hasto move up for the option to be knocked out.

Down-and-out: spot price starts above the barrier level andhas to move down for the option to become null and void.

Up-and-in: spot price starts below the barrier level and has tomove up for the option to become activated.

Down-and-in: spot price starts above the barrier level and hasto move down for the option to become activated.

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Barrier Options (Example)

A European call option may be written on anunderlying with spot price of $100, and a knockoutbarrier of $120.

This option behaves in every way like a vanilla

European call, except if the spot price ever movesabove $120, the option "knocks out" and thecontract is null and void.

Note that the option does not reactivate if the spot

price falls below $120 again. Once it is out, it's outfor good.

Knock out barr ier options

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Knock out barr ier options

Knock out options get knocked out (dead or cease toexist) only when the spot rate hits the specified

barrier or either of the two barriers.

There are two kinds of knock out barriers in India:

- Up and out knock out

- Down and out knock out

Knock in barr ier options

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Knock in barr ier options

Knock in options get knocked in (come alive)

only when the spot rate hits the specified barrier

or either of the two barriers.

There are two kinds of knock in barriers:

- Up and in knock in

- Down and in knock in

Knock out + Knock in options with same strike &

barriers equals plain vanilla option.

Euro import portfol io

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Euro import portfol io

You have Euro imports EUR/USD Spot 1.2870

Worst case rate 1.31

Time 6 months 6M Forward rate 1.2920

Volatility 9.5% / 10%

6M USD Libor2.99%

6M Euro Libor2.19%

Smart Forward (SF)

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Smart Forward (SF)

Zero cost exotic hedge

Plain out of the money option as long as a specified

in the money trigger is not hit

Option gets transformed into a out of the moneysynthetic forward contract if the trigger is hit

If the market view turns out to be wrong, there can be

an opportunity loss, and

The SMART FORWARD becomes a DUMB

BACKWARD

Smart Forward

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Smart Forward

1.14

1.16

1.18

1.2

1.22

1.24

1.26

1.28

1.3

1.32

1.2

1.21

1.22

1.23

1.24

1.25

1.26

1.27

1.28

1.29 1.

31.31

1.32

1.33

1.34

1.35

1.36

1.36

1.36

Spot at Maturity

NetEffec

tiveRate

Buy Euro Call at 1.31, Sell Euro Put at 1.31

with KI at 1.1925

Choice Forward (CF)

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Choice Forward (CF)

Zero cost exotic hedge

Involves buying an in-the-money option with two

knock out barriers.

Also simultaneously buying an out-of-money option

with the same two knock in barriers (A)

Also selling in-the-money option with same two

knock in barriers (B)

(A) & (B) put together constitute an out-of-money,

double knock-in, synthetic, forward contract

Choice Forward

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1.18

1.19

1.2

1.21

1.221.23

1.24

1.25

1.26

1.27

1.28

1.15

1.17

1.19

1.21

1.23

1.25

1.27

1.29

1.31

1.33

1.35

1.37

1.39

1.41

Spot at Maturity

NetEffec

tive

Rate

Buy Euro Call at 1.27 with KO at 1.38 & 1.20, Sell Euro Put at 1.31

with KI at 1.38 & 1.20, Buy Euro Call at 1.31 with KI at 1.38 and 1.20