[sacredtheory]

Hey guys, I’ve been lurking on this forum now for a few months. I’ve got my first test coming up (BEC), and I’m using the Ninja notes as well as the Wiley book and online test bank. But there’s one particular topic I occasionally see in the online MCQ’s, and it’s only briefly mentioned in the text book, and I can’t seem to wrap my head around it.

I’m hoping maybe one of you can simplify it for me, perhaps shed some light on a trick for remembering the differences. Here’s an example question from Wiley:

An American importer expects to pay a British supplier 500,000 British pounds in three months. Which of the following hedges is best for the importer to fix the price in dollars?

A. Buying British pound call options.

B. Buying British pound put options.

C. Selling British pound put options.

D. Selling British pound call options.

Answer A is correct. The requirement is to determine which hedge is best to hedge the payment of British pounds in the future. Answer A is correct because a call option allows the importer to lock in the price of British pounds at the current exchange rate.

Answer B is incorrect because buying British pound put options allows the importer to sell British pounds at a fixed price in the future.

Answer C is incorrect because selling British pound put options allows the purchaser to sell British pounds at a fixed price in the future.

Answer D is incorrect because selling British pound call options allows the purchaser to purchase British pounds at a fixed price in the future.

I think my problem is just trying to remember when each option would be a valid option. Some of the Wiley questions revolve around future payments, receivables, payables, etc, all in foreign currency, but for some reason my mind just goes blank when trying to remember which one is which.

Thanks!

Jared

BEC: Passed
AUD: Passed
REG: Passed
FAR: Passed

Jared

[ScruffMcGruff]

Well, to start out, the correct answer to any hedging question like this is NOT going to include SELLING the options (call or put). This is because you don't actually decide whether or not the option will get used (obviously the person that bought the option will decide that).

As for buying Calls and Puts, I'll go over it real quick:

**(A)** Buying a Call Option: You lock in the CURRENT price/exchange rate and may BUY the optioned item at any time for that same price/exchange rate until the option expires.

You ‘WIN' if the actual FMV of the item INCREASES after you buy the call option because you will be able to call in the option at the lower price and then theoretically sell that item back in the open market for the higher price/exchange rate.

EXAMPLE 1: You buy a call option on January 1st that allows you to buy 1,000 pounds of Copper for $1.10/pound at any time throughout the year. On December 31st, the current price of Copper is $1.2/pound. In this case, you ‘WIN' because if you exercised your option you would spend $1,100 buying 1,000 pounds of Copper. You could then turn around and sell the copper for $1,200 (1.2 x 1000) on the open market. You would make a PROFIT of $100 (not taking into account the price of buying the option…)

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**(B)** Buying a Put Option: You lock in the CURRENT price/exchange rate and may SELL the optioned item at any time for that same price/exchange rate until the option expires.

You ‘WIN' if the actual FMV of the item DECREASES after you buy the put option because you will be able to use the put option at the higher price and re-buy the item at a lower price.

EXAMPLE 2: You buy a put option on January 1st that allows you to sell 1,000 pounds of Copper for $1.30/pound at any time throughout the year. On December 31st, the current price of Copper is $0.90/pound. In this case, you ‘WIN' because you could buy 1,000 pounds of Copper at the current market rate for $900 (0.90 x 1000) and then turn around and sell it back via your put option for $1,300 (1.30 x 1000). You would make a PROFIT of $400 (not taking into account the price of buying the option…)

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Alright, hopefully you are still with me!

As for using options to hedge another transaction, you are usually going to use a CALL option when you are BUYING things because you are worried about having to pay MORE at the actual transaction date. If this is indeed the case and you have a similar call option in place, the increase in the value of the item you are buying will be offset by the profit you will have made on your call option. (Again you ‘WIN' with a CALL when prices INCREASE)

On the other hand, for PUT options, they are generally used when you are SELLING something because you are worried that the value of your merchandise will be worth LESS at the actual transaction date. If this is the case and you have a similar put option in place, the decrease in the value of your merchandise will be offset by the profit you make on your put option. (Again you ‘WIN' with a PUT when prices DECREASE)

Hopefully this makes sense now if you apply the two examples I went over above with the last two paragraphs I just wrote. If you need any more help, just post a reply.

AUD - 85
FAR - 78 (lol@ FAR Sims)
REG - 85
BEC - August

[sacredtheory]

Wow, thanks for the in-depth explanation! That definitely helps 🙂

BEC: Passed
AUD: Passed
REG: Passed
FAR: Passed

Jared

[Anonymous]

Here's what got me through these BEC problems: You're either going to have a foreign currency Accounts Receivable or Accounts Payable problem. Combine that with puts vs. calls terminology (and throw in some comments about this currency appreciating or depreciating against that one) and it can get confusing.

Draw your T-account with, for example, your A/P liability for 100 British pounds. Now, ask yourself, what's the worst thing that can happen? (thus, the rationale to hedge). Dollars go waaay down (depreciate), pounds go waay up (appreciate). Oh, no, what to do? If that happens, you'll have to give up lots and lots of dollars to go get the pounds at American Express or wherever to pay that darn liability. You want to buy a call option (CALL the pounds — here, here, little pounds, come to me at the current price) and be able to get the pounds in your pocket at the current price, not the bad (possibly) future high price.

If it's an A/R situation, again draw your T-account with 100 British pounds and ask, what's the worst that can happen? Those pounds go waaay down against the dollar and you get diddly when the A/R clears. You take the pounds to American Express and you get a handful of change in dollars. Bummer. So take those (potentially) crummy pounds and, quick, be able to PUT them in someone else's account by buying a put option — you can sell the pounds to them at the nice, current price.

This methodology will also help if the question set up is couched in some murky blather about exchange rates. You can generally ignore the actual amounts and plug in 10 or 100 (so you don't have to deal with 8 million yen and all those trailing zeros).

Agree with Scruff, it is probably safe to ignore any answer choices that have you selling options; you're not a currency trader.

On a related matter, don't forget terminology — “spot” is current rate, vs. forward or future rate. Also the rates can be in terms of either currency, EUR 0.735342 = USD 1.00 or EUR 1.00 = USD 1.35991. So it can be a little counterintuitive, if the Euro number goes DOWN in the first formula, good for the Euro, it's appreciating, and in the second formula, if the dollar number goes UP, good for the Euro, bad for the dollar, it's depreciating. Again, use your T-account and do the conversion to figure out if you're winning or losing. (relates more to FAR problems.)

[Author]

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