• Introduction to World First’s Hedging Service
• The Participating Forward
• The Protection Option
• The Risk Reversal

The Protection Option

A protection option for a UK citizen selling their property in America

Mr Bellagio is due to receive $1m in six months from the sale of his property in America. Although the sale has yet to be signed, the protection option provides him with a guaranteed worst case rate to convert the dollars to pounds in six months. If he has not sold the house by then, there is no obligation for him to actually sell the dollars and buy the pounds.

When he was entering into the protection option, the exchange rate was 1.98 and the six month forward contract rate was 1.95. Mr Bellagio felt that the rate might fall further but didn't want it to go back over 2.00 as this would have reduced the number of pounds he would receive for his dollars. He bought a protection option at 2.00 for a cost of 1.5% of the notional amount (ie $15,000 or £7,600*). This meant that regardless of what happened to the exchange rate over the next six months, if the rate was higher than 2.00 on the pre-agreed date in six months' time, he could convert his dollars into pounds at 2.00. There are four potential scenarios for this example:

1) If he had sold his American property and the prevailing rate in six months is 2.20

Mr Bellagio would exercise his right to sell $1m at 2.00 and receive £500,000 in return

2) If he had sold his American property and the prevailing rate in six months was 1.90

Mr Bellagio would sell his $1m at 1.90 and receive £526,315.79 in return

3) If he hadn't sold his American property and the prevailing rate in six months was 2.20

Mr Bellagio would exercise his right to sell $1m at 2.00 and he would buy $1m back at the prevailing exchange rate of 2.20 through World First Markets Ltd. The net result of this would be that World First Markets Ltd would send Mr Bellagio £45,454.54 and there would be no other cashflows

4) If he hadn't sold his American property and the prevailing rate in six months was 1.90

There would be no exchange of monies in this situation as the protection option he has purchased is worthless and he does not need to sell dollars and buy pounds as he has not yet sold his house

The downside of this strategy is that Mr Bellagio would have paid an unnecessary premium if either of the following two scenarios occur

*Using a £ / $ exchange rate of 1.97, effective May 2008

World First Markets Limited is authorised and regulated by the Financial Services Authority. Our Firm Reference Number is 477561