Currency Derivatives: Options v/s Forwards
As the year 2018 draws to a close, the value of the Indian Rupee continues to plummet. Losing more than 60% of its value since 2010, it has been continuously depreciating against the US dollar for nine consecutive years. This persistent trend makes the practice of pre-booking dollars in advance at fixed prices a handy tool to save money on foreign currency spending. In this regard, options and forwards are two financial contracts that enable individuals to reserve foreign currency. To gain a clear understanding of the specifics of these contracts, let’s consider a small example:
Mr. A has to spend $10,000 to pay for his child’s education after six months in July. Currently, in the month of February, the dollar is trading at INR70. Following the current trend, Mr. A expects it to reach to INR 75 by July. According to Mr. A, his child’s education, which currently (in February) costs INR 700,000, will cost INR 750,000 (in July) when his son actually starts his studies abroad and requires the money.
In a bid to make a diligent financial decision, Mr. A wants to buy $10,000 at the current price of INR70 (in February) but wishes to receive and use it after six months (in July). Talking to his bank representative, he learns about forwards and options contract and now compares the two to see how they may benefit him.
In February: Mr. A makes an agreement with Bank B in February to purchase $10,000 dollars at a price of INR 71 in July. Although the current price is INR 70, Mr. A would still profit at buying them at INR 71 as he expects the price to jump to INR 75.
The Bank asks Mr. A to pay an initial margin of INR 50,000 to finalize the contract and ensure that Mr. A does not backtrack from it later.
Between February to July: If the price of the dollar remains at 70, or increases to 75, things will be smooth. However, if it uncharacteristically drops to 65, and the contract goes against Mr. A, he will be required to pay a margin i.e. the money to ensure that he would not back down from the contract. This margin would be deducted from INR 710,000 that he will pay in July.
In July: Mr. A has to honor his agreement and purchase $10,000 at INR 71 from Bank B. The margin paid by him would be deducted from INR 710,000 that he is liable to pay. It does not matter whether the price of the dollar has increased or decreased.
A forward will obligate a buyer to buy the currency at a preset price at a predefined date. The buyer of an option will have to purchase the currency, irrespective of its price in that period. The buyer of a forward needs to post a small initial margin and, if the contract moves against the buyer, he may have to post extra margin as well.
In February: Mr. A buys a ‘Call’ option (right to buy at maturity) worth $10,000 at a price of INR 71, which matures in July. To secure this option, the issuing Bank B asks the buyer to pay a premium of INR 15,000. The paid premium will not be deducted from the final payment if Mr. A choses to use his contract.
Between February to July: No activity expected from the buyer.
In July: The buyer can now choose to purchase the dollars depending on whether it is profitable for him or not. Considering the two scenarios that Mr. A may face the below-mentioned scenarios:
- If the price of a dollar goes below INR 71: Although Mr. A expected the rupee to devalue, it didn’t. It is therefore not profitable for Mr. A to buy $10,000 dollars at a price of $71 from the option as he can buy it at a cheaper rate in the market. Therefore, the buyer can choose to not exercise the option. In this case, he loses his premium but protects himself from a possibly larger loss.
- If the price of a dollar goes above INR 71: Mr. A would want to exercise the contract and, therefore, buys $10,000 at 710,000. The INR 15,000 is not deducted from the total price.
- An option contract would give a buyer a choice of buying the currency at a preset price on a predefined date for a small premium price. An option contract becomes profitable only when the fluctuation in the currency is high enough to offset the premium
Forward v/s Option v/s No Contract
Consider the three scenarios where the future price may alter, understanding the utility of engaging in these contracts for Mr. A. assuming that Mr. A wants to buys $10,000 at a future price of INR 71.
If the price of a dollar becomes 65 at maturity:
- Forward: Mr. A has to purchase $10,000 at INR 710,000, thus sustaining a loss of INR 60,000.
- Option: Mr. A can choose to not exercise the option and purchase $10,000 at a market price of 65 at INR 650,000; and incurs a loss of only INR 15,000 premium.
- No Contract: Mr. A can purchase $10,000 at INR 650,000 i.e. the market price.
If the price of a dollar becomes 75 at maturity:
- Forward: Mr. A purchases $10,000 at INR 710,000; thus, saving INR 40,000.
- Option: Mr. A can choose to exercise the option and purchase $10,000 at the decided price of INR 71 at INR 710,000. As Mr. A has paid a premium of INR 15,000 initially (to secure the contract), he saves INR 25,000.
- No Contract: Mr. A can purchase $10,000 at 750,000 i.e. the market price.
Using an options, forward or no contract would depend on one’s assessment related to currency forecast. For buyers who want to hedge against the risk of the appreciating currency, options may be a costlier but better alternative. On the other hand, buyers who are confident that the currency will devalue can opt for forward as it may save them the cost of paying the premium. If one feels that there may be only small devaluations in the rupee, a forward may be a better choice as one is not required to pay a premium or an extra charge on the contract. To conclude, both option and forward contracts have their own benefits and can be used as powerful tools to hedge against uncertain fluctuations in currency.