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Currency option: example

Wyleth plc is a UK-based media group that wants to divest itself of part of its trade - the publication of a number of business and specialist magazine titles - in order to concentrate on its core business. It negotiates a sale of the titles to an Australian group for Aus$12 million.

However, the sale contract contains a number of conditions precedent, which must be satisfied before the sale can be completed. The earliest time when Wyleth plc could receive the Aus$12 million is in 30 day鈥檚 time; the latest time is in 6 months. It is also conceivable (though unlikely) that the whole deal might fall through.

The exchange rate when the contract is signed is 拢1/Aus$2.7150, so that Aus$12 million is worth 拢4,419,890. But the Australian dollars might be worth more or less than that when they are actually received. The company could enter into a forward contract to sell Aus$12 million at an agreed rate in 6 months, but this is relatively inflexible - it might receive the money considerably earlier than that. So the company decides to hedge the risk by buying an Australian dollar put option.

The 6-month forward rate on the Australian dollar is 拢1/Aus$2.6985. The company buys from a bank a put option giving it the right (but not the obligation) to sell the Australian dollars at a rate of 拢1/Aus$2.6985. The option expires in 6 months鈥� time, and is exercisable on any business day up to the expiry date (an American-style option). The company pays the bank a premium of 拢63,000 for the option.

Scenario 1

Five months later, Wyleth plc receives the sale proceeds, Aus$12 million. The spot rate is 拢1/Aus$2.5970. Thus if the company were to sell the Australian dollars at the spot rate, it would receive 拢4,620,716.

If it exercised the option and sold the dollars at a rate of 拢1/Aus$2.6985, it would receive only 拢4,446,915. It lets the option lapse and sells the dollars in the spot market.

Scenario 2

The facts are the same, except that the spot rate when the sale proceeds are received is 拢1/Aus$2.8191. The Aus$12 million is therefore worth 拢4,256,678 at spot rates. Therefore the company exercises the option and sells the Australian dollars for 拢4,446,915.

In each of these scenarios, has the company benefited from buying the option? One way of looking at this is to say that the Aus$12 million was worth 拢4,419,890 when the contract was signed. When the proceeds were received, under Scenario 1 the figure was 拢4,620,716 - an exchange gain of 拢200,826. By abandoning the option and selling the currency in the spot market, the company is able to benefit from that gain - but it has had to pay a premium of 拢63,000. So its profit is reduced to 拢137,826.

Under Scenario 2, the Aus$12 million was worth 拢4,256,677 when received - an exchange loss of 拢163,213. By exercising the option, the company avoids the loss. It knows that, however much the Australian dollar fluctuates, it will always receive at least 拢4,446,915. That assurance has cost it 拢63,000.

This can be summarised as saying that the option protects the company from adverse exchange movements while still allowing it to profit from advantageous movements - but at the cost of paying an up-front premium.