This section explains two of the many uses of options that rely upon the ability of the option buyer to abandon the option at no extra cost. The first is the purchase of options to insure against a fall in the value of a currency. The second is the hedging of the currency risk in a foreign currency tender.

Purchasing options as a form of insurance

If a US investment manager has strong expectations of a rise in the value of Sterling but wishes to insure against being totally wrong, slightly out-of-the money puts will provide the required insurance.

Take, for example, a situation where the current US dollar spot rate is 1.8500 and a 1.825 put with 103 days to maturity costs 3.15 cents per pound Sterling. The put protects against any fall below 1.8250, a fall of 2.5/185.0 = 1.35%. Such a fall would result in a total loss, including option premium, of 3.15 + 2.5 = 5.65/185.0 = 3.05% over 103 days.

The break-even rate for this strategy is 1.9065; if the currency were to rise above that figure, the option would expire worthless and the currency sold in the market for a profit. Clearly strong expectations of a substantial rise in the currency will be required before the case for spending the option premium can be justified.

Hedging the currency risk in a tender application or a fixed price application that may be oversubscribed

When an investor tenders for a foreign currency investment, there is a risk that he or she may not be successful in the tender and also that if successful there is the risk that the foreign currency appreciates vis-à-vis the home currency in the period between tendering and when payment is due.

There are two distinct time periods in the tendering process: first, the period between delivering the tender and the announcement of the tender outcome; and secondly, the period between the announcement and the payment by the successful tenderers. During the first period the tenderer does not know whether there will be a need for foreign currency. During the second period, if there is a need to pay foreign currency, there is the risk that the currency will appreciate.

If the tenderer were to hedge the potential currency risk with forwards or futures, there is exposure to the risk of not being successful in the tender. If in the meantime the currency has depreciated, there will be a loss if the hedging transaction is not ultimately required.

An alternative hedging strategy is to buy call options that mature at the time payment is due. This will lock in the exchange rate at which the payment will be made if indeed one has to be made.

On the date that the results of the tender are announced, the tenderer has a choice. If the tender has been unsuccessful, the options can be sold in the market in order to recoup some of the cost of the hedge. If the currency has appreciated sufficiently, a profit can be realized. If the tender was successful, the investor can choose between maintaining the current option hedge or selling the option and covering in the forward market. This decision will be influenced by the amount of time value remaining in the option premium. If it is substantial, it may be better to sell the options and enter into a forward hedge.

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