THE INSTRUMENT. Options can be used for hedging currency exposures when a corporate is not sure which way the currency is going to move. By entering into an option contract, the CFO gets the best of both worlds: his downside is restricted to the premium that he pays, and he enjoys an unlimited upside. For the buyer of an option, the gains are unlimited and the losses are limited. For the writer of the option, the losses are unlimited and the gains are limited to the extent of the premium he gains.

The value of a currency option consists of two components:

• The intrinsic value, or the amount by which an option is in the money. A call option whose exercise price is below the current spot price of the underlying instrument, or a put option whose exercise price is above the current spot price of the underlying instrument, is said to be in the money.
• The extrinsic value, or the total premium of an option less the intrinsic value. It is also known as the time value or the volatility value. As the expiry time increases, the premium on an option also increases. However, with each passing day, the rate of increase in the premium decreases. Conversely, as an option approaches expiry, the rate of decline in its extrinsic value increases. This decline is known as the time decay. Therefore, the more volatile a currency, the higher will be its option value.

THE EXAMPLE. Company X is importing machinery for DM 1 million. At the time the deal was struck, the DM was trading at 1.7600 to the dollar. Payment has to be made by April 30, 1998. The DM has already depreciated to 1.7700, and the company has made a tidy profit. The CFO believes that the dollar will continue to gain against the DM, but he would not like to lose the gains already made. Therefore, he buys an in-the-money DM call option, by paying an upfront premium of 2.01 per cent. If on April 30, 1998, the DM is above 1.7900, he will let the option lapse; on the other hand, if the DM is 1.7200, he would exercise the option, and buy DM at the pre-determined rate of 1.7600.

THE REGULATIONS. In January, 1994, corporates were permitted to use currency options as a hedging product. In the absence of a rupee-yield curve, rupee-based currency options were not permitted since the pricing of such options would have been arbitrary. Therefore, the banks were allowed to offer only cross-currency options on a fully-covered basis. And the option could be cancelled only once; CFOs were not permitted to re-book options against the same exposure. They could, however, hedge the exposure using the forward market.

In September, 1996, corporates were allowed to freely book and cancel options. But rupee-based options are still not permitted by the RBI.

RANGE-FORWARDS

THE DEFINITION. A range-forward involves the simultaneous purchase and sale of an option at different strike prices, but having the same maturity date and the same principal amount.

THE INSTRUMENT. While an option provides a corporate the flexibility to benefit from upside movements while limiting downside risks, it has an associated cost: a high upfront premium. By setting a ceiling on the potential gains, a range-forward trades off some of the upside for a lower premium.

THE EXAMPLE. Company X is importing machinery worth DM 1 million. Although the CFO wants to insure against downside losses, he finds the option premiums exoRBItant. In exchange for a lower premium, say 0.5 per cent, he is willing to give up some of the upside gains if the DM moves above 1.7600. So, he buys a range-forward, which limits the fluctuation of the DM to a band between 1.7600 and 1.7200.

THE REGULATION. In September, 1996, the RBI's Exchange Control Manual was amended to allow the banks to offer range-forwards to corporates to hedge their foreign exchange exposures, provided the net premium paid by the corporate was non-negative. This implies that a corporate cannot buy a range-forward which would result in a cash inflow by way of premium. The best that a corporate can do in such a situation is to opt for a zero-cost range-forward.

RATIO RANGE-FORWARDS

THE DEFINITION. A ratio range-forwards is an improved version of the basic range-forward. The difference is that the principal amounts on the two options differ. The buyer gets full protection on the downside, but shares the profits with the writer in a pre-determined ratio if the currency moves above a speculated level.

THE INSTRUMENT. In the case of the range-forward, the buyer sacrifices the benefit of favourable movements in the currency beyond a pre-determined level for a lower premium. However, with the ratio range-forward, the buyer shares the profits in a pre-determined ratio if the currency moves above a pre-determined ceiling. As this is an additional benefit, the ratio range-forward is more expensive.

THE EXAMPLE. Consider the case of a CFO who would like to restrict his downside to DM 1.7200 to the dollar. However, he does not want to rule out the possibility of a strong dollar appreciation. The ideal instrument would be a ratio range-forward, which allows the CFO to have a specified share--say, 30 per cent--in the gains if the DM crosses the 1.7600-mark.

THE REGULATION. These derivative products can be freely booked and cancelled. However, the restriction barring the net inflows of premium to corporates still applies.

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