Question

4 Scenarios with the use of call options when the investor believes the foreign currency may appreciate. tell me how the investor can use options if he believes the currency may depreciate. What options should the investor buy or sell? Tell me what happens if the investor buys this option and the option finishes 1) in the money, and 2) out of the money. Additionally, tell me what happens if the investor sells this option and the option ends both in the money and out of the money.

Answer 1

When Foreign Currency Appreciates:

Question : What option should you buy or sell?

Answer : You should buy call option. This is because buying call option gives the buyer the right but not obligation to buy the underlying asset at the agreed price or strike price. For this you pay a premium. When you expect the foreign currency to appreciate, it means you will have to spend more local currency to buy each unit of the foreign currency in future, hence if you buy the right to purchase the foreign currency at a fixed rate, you can limit your loss buy exercising the option if the currency actually appreciates on maturity date. On the contrary if the foreign currency depreciates on maturity date, you can skip the option without exercising it and buy the foreign currency from the open market at the lower price, thus ensuring your profit. Also if it appreciates but its appreciated market rate on maturity is lower than your strike price, you still can skip the option without exercising it and buy the foreign currency from the open market, thus being profitable still.

Scenario 1: ITM (In-the-Money):

Suppose you buy 1 month USD/INR @ 71.92 (Strike Price) and pay a premium (price of purchasing the call option) of INR 0.25 per USD. On the date of maurity, i.e. after 1 month, the market price of USD/INR is 72.50. So, you should decide to exercise the option and buy 1 USD @ INR 71.92. Thus your profit will be INR 72.50 - INR(71.92+0.25) = INR 0.33 per USD purchased by you.

Scenario 2: OTM (Out-of-the-Money):

Suppose you buy 1 month USD/INR @ 71.92 (Strike Price) and pay a premium (price of purchasing the call option) of INR 0.25 per USD. On the date of maurity, i.e. after 1 month, the market price of USD/INR is 71.10. So, you should decide to skip the option and instead buy 1 USD @ INR 71.10 from the open market. Thus your profit will be INR 71.92 - INR(71.10+0.25) = INR 0.57 per USD purchased by you.

When Foreign Currency Depreciates:

Question : What option should you buy or sell?

Answer: You should sell call options, which is also called writing an option. Selling a call option gives the seller an obligation to sell the underlying asset at the agreed price or strike price. For this you get a premium from the buyer. When you expect the foreign currency to depreciate, it means the buyer on maturity date will not exercise the option and skip it and rather buy from the open market as price of the currency is lower in open market. Thus you need not buy any currency from the open market to sell to the buyer. Your end up making a profit which is the premium received initially.

Scenario 1: ITM (In-the-Money):

Suppose you sell 1 month USD/INR @ 71.92 (Strike Price) and receive a premium (price of purchasing the call option) of INR 0.25 per USD from the buyer. On the date of maturity, i.e. after 1 month, the market price of USD/INR is 72.50. So, the buyer will decide to exercise the option and buy 1 USD @ INR 71.92. For this you will have to purchase USD from the open market @ INR 72.50 per USD. Thus you will end up being in loss, which is INR 71.92 - INR(72.50-0.25) = - INR 0.33 per USD sold by you.

Scenario 2: OTM (Out-of-the-Money):

Suppose you sell 1 month USD/INR @ 71.92 (Strike Price) and receive a premium (price of purchasing the call option) of INR 0.25 per USD from the buyer. On the date of maturity, i.e. after 1 month, the market price of USD/INR is 71.10. So, the buyer will decide to skip the option and instead buy 1 USD @ INR 71.10 from the open market. Thus your profit will be INR 0.25 per USD sold by you which is the premium received by you while selling the option initially.