20 November 2008
The Protection Option - Importer
The protection option provides clients with the right to buy a currency on a pre-determined forward date at a pre-determined rate. However, at expiry, the client can elect not to exercise the protection option and buy in the spot market if the spot rate is more advantageous. The protection option combines the certain protection provided by a forward contract and the flexibility of being able to leave an exposure unhedged. A premium is payable for a protection option.
How does a protection option work?
For example, let's assume a client imports furniture from the US, and needs to buy US$1 million in six months' time to pay a supplier.
The forward rate for six months is 2.0000 and the client doesn't want to get a worse rate than 2.0000.
The client would purchase a protection option at 2.0000 maturing in six months' time. A premium of $30,000 would be payable to World First for the protection option. If, at maturity, the exchange rate is trading below 2.0000, the client would simply exercise the protection option and buy the US dollars at 2.0000. If, at maturity, the exchange rate is trading at 2.1500, the client simply transacts in the spot market and achieves a rate of 2.1500.
We have built the premium cost into the hedge rate in the graph below. Therefore, if the exchange rate is trading at 2.1500 two days before settlement, the effective hedge rate will be 2.1500 minus the initial premium cost of $30,000, which would move the effective hedge rate down to 2.0900.
Please note that this graph and any figures and terms cited are for illustrative purposes only.
Advantages
Disadvantages
The Protection Option - Exporter
The protection option provides clients with the right to sell a currency on a pre-determined forward date at a pre-determined rate. However, clients can elect not to exercise their protection option and sell the currency in the spot market if the spot rate is more advantageous. The protection option combines the certain protection provided by a forward contract and the flexibility of being able to leave an exposure unhedged. A premium is payable for a protection option.
How does a protection option work?
For example, let's assume a client exports widgets to the US, and she forecasts that she will need to repatriate US dollar proceeds of US$1 million in six months' time.
The forward rate for six months is 2.0000 and she doesn't want to get a higher rate than 2.0000 but the client thinks that sterling is going to weaken against the dollar.
She would purchase a protection option at 2.0000 maturing in six months' time. A premium of $30,000 would be payable to World First for the protection option. If, at maturity, the exchange rate is trading above 2.0000, she would simply exercise the protection option and sell the dollars at 2.0000. If, at maturity, the exchange rate is trading at 1.8500, she simply deals in the spot market and achieves a rate of 1.8500.
We have built the premium cost into the hedge rate in the graph below. Therefore, if the exchange rate is trading at 1.8500 two days before settlement, the effective hedge rate will be 1.8500 plus the initial premium cost of $30,000, which would move the effective hedge rate up to 1.9100.
Please note that this graph and any figures and terms cited are for illustrative purposes only.
Advantages
Disadvantages
World First Markets Limited is authorised and regulated by the Financial Services Authority. Our Firm Reference Number is 477561
