Understanding corporate finance: derivative contracts: currency option
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’s 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 £1/Aus$2.7150, so that Aus$12 million is worth £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 £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 £1/Aus$2.6985. The option expires in 6 months’ 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 £63,000 for the option.
Five months later, Wyleth plc receives the sale proceeds, Aus$12 million. The spot rate is £1/Aus$2.5970. Thus if the company were to sell the Australian dollars at the spot rate, it would receive £4,620,716.
If it exercised the option and sold the dollars at a rate of £1/Aus$2.6985, it would receive only £4,446,915. It lets the option lapse and sells the dollars in the spot market.
The facts are the same, except that the spot rate when the sale proceeds are received is £1/Aus$2.8191. The Aus$12 million is therefore worth £4,256,678 at spot rates. Therefore the company exercises the option and sells the Australian dollars for £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 £4,419,890 when the contract was signed. When the proceeds were received, under Scenario 1 the figure was £4,620,716 - an exchange gain of £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 £63,000. So its profit is reduced to £137,826.
Under Scenario 2, the Aus$12 million was worth £4,256,677 when received - an exchange loss of £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 £4,446,915. That assurance has cost it £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.