The Use Cases for U.S. Dollar-Settled Foreign Currency Options

Articles From: Nasdaq
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Head of Index Options Content

Nasdaq

Derivative markets developed in large part as tools to offset a preexisting price risk. In 1982, the Nasdaq PHLX (PHLX®) introduced options on currencies. Over the past four decades, trillions worth of notional exposure has been traded in the U.S. Dollar (USD) for products linked to major foreign currencies.

The use case scenarios are varied, as are the end users. Multinational corporations based in the U.S. may use the products to manage foreign currency risks related to overseas revenues. Investment banks, money managers and other institutional users might look to hedge risk tied to foreign stock or bond holdings. Individual and institutional market participants could use these options to express an outlook or hedge risk on a specific foreign currency.

An example will help illustrate the potential benefit associated with U.S. Dollar-Settled Foreign Currency Options.

James and Mary are a retired couple living in a coastal U.S. city. They plan to purchase a boat from a Mediterranean Marine Company (MMC). The invoice for the new vessel totals €500,000. The funds are due in nine months. 

The couple has set aside $492,500 based on the current USD to Euro exchange rate (0.985). The funds will sit in an interest-bearing account until the final bill comes due in 270 days. The interest on the funds will bring the account value to $510,000 in nine months.

The final payment must be made in Euros, so their risk over the next nine months is tied to Euro strength relative to the USD.

Euro US Dollar settled foreign currency

Source: Live Vol Pro

Over the past 10 years, the USD/EUR cross has ranged between (0.975 – 1.38). The spot rate for currencies changes intraday, just like the value of equities or commodities. If, for example, the cross rate moved back to 1.10 when the invoice comes due, the couple would need $550,000 to pay for the boat.

Today it requires $0.985 to buy €1, but in Q1 of 2014, it required $1.38 to buy €1. Currency markets have become more volatile in recent years. Central banks globally have shifted towards less accommodative monetary policies. Interest rates have been rising in the U.S. and elsewhere, which correlates to currency volatility.

What if the USD continues to strengthen relative to the Euro and the cross falls to 0.85? In that situation, they would benefit because it would only require ($500,000*0.85) = $425,000 to complete the transaction.

To offset their currency risk, James and Mary decide to use Nasdaq Foreign Currency Options. There are multiple expiries and option strikes/series, so they can customize their risk offset. The couple wants to minimize their premium outlay on the currency transaction.

The interest earned on the funds will total ~$17,500 when the invoice comes due. They are willing to use that money to establish a hedge.

As a result, they decide to sell 100 of the XDE nine-month 102.50 strike puts at 2.75 each. They also sell 100 of the nine-month XDE 0.95 strike calls at 2.00 each. The total premium outlay is $7,500. The options expire at 12:00 pm EST on the third Friday of the expiration month.

Both the long call option and short put option on XDE benefit from Euro strength relative to the USD. As such, the option position is used as a hedge against an adverse currency move for James and Mary.

Hypothetical scenarios:

USD/EUR spot level settlement at 0.985 (unchanged relative to present).

Implications (Hedge is a cost):

  • The hedge would lose the $7,500 in premium paid.
  • James and Mary will need ($500,000*0.985) $492,500 USD to complete the transaction.
  • They have $510,000 in the account because of the interest earned.
  • Net of hedge, they have ($510,000 – $492,500 – $7,500) $10,000 left in savings after the purchase.

USD/EUR spot level settlement at 0.940 (Euro is weaker relative to the USD).

Implications (Stronger dollar is a benefit; hedge is cost):

  • The short 95.00 strike puts are worth $100 each ($10,000 total). The calls expire OTM (worthless). The hedge is down $10,000 plus the premium paid to enter the position ($7,500). They lose $17,500 on the hedge.
  • James and Mary will need ($500,000*0.940) $470,000 to complete the transaction.
  • They have $510,000 in the account because of interest earned.
  • Net of the hedge, they have ($510,000 – $470,000 – $17,500) $22,500 left in savings after the purchase.

USD/EUR spot level settlement @ 1.05 (Euro is stronger relative to the USD).

Implications (Weaker dollar is a cost; hedge is a benefit):

  • The long 102.50 strike calls are worth $250 each ($25,000 total). The short puts expire OTM (worthless). The hedge makes ($25,000 – 7,500) $17,500.
  • James and Mary will need ($500,000*1.05) $525,000 to complete the transaction.
  • They have $510,000 in the account because of interest earned.
  • Net of the hedge, they have ($510,000 + $17,500 – $525,000) $2,500 left in savings after the purchase.

USD/EUR spot level settlement @ 1.15 (Euro is significantly stronger relative to the USD).

Implications (Weaker dollar is a significant cost; hedge is a significant benefit):

  • The long 102.50 strike calls are worth $1,250 each ($125,000 total). The short puts expire OTM (worthless). The hedge makes ($125,000 – $7,500) $117,500.
  • James and Mary will need ($500,000*1.15) $575,000 to complete the transaction.
  • They have $510,000 in the account because of interest earned.
  • Net of the hedge, they have ($510,000 + $117,500 – $575,000) $52,500 left in savings after the purchase.

USD/EUR spot level settlement @ 0.85 (Dollar is significantly stronger relative to the Euro).

Implications (Stronger dollar is a significant benefit, hedge is a significant cost):

  • The short 0.95 puts are worth $1,000 each (down $100,000). The short calls expire OTM (worthless). The hedge amounts to a loss of ($100,000 + $7,500) ($107,500).
  • James and Mary will need ($500,000*0.85) $425,000 to complete the transaction.
  • They have $510,000 in the account because of interest earned.
  • Net of the hedge, they need ($510,000 – $425,000 – $107,500) $22,500 more to cover the cost of the boat and the hedge.

The couple understands their alternatives. They know the historical range for the USD relative to the Euro. They consider the probability of a much weaker Euro (significantly stronger USD) to be low. They are most concerned about the potential for dollar weakness which, absent a hedge, would make their transaction more expensive.

Currency options can be used in a variety of ways. We highlighted one use case for a future transaction in a foreign currency. For more information, visit this page.

Originally Posted November 21, 2022 – The Use Cases for U.S. Dollar-Settled Foreign Currency Options®

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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For the sake of simplicity, the examples included do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy.

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