PROTECTING EXPORT COST WITH BUY PUT OPTION

Companies in business of export and import are exposed to currency risk. It is wise to protect the cost of transaction against currency fluctuations. Companies can mitigate currency fluctuation risk by Forwards, Futures and Options. 

Normally most of the companies do not have access to banks for managing risk through options but trading platforms like NSE and BSE currency permits use of options as a tool to manage currency risk without any restrictions.

Options provide three key benefits –

· It is cost efficient

· It is more efficient in risk management than currency Forwards &  futures

· It is a strategic alternative to currency Forwards / futures

A currency option is a contract that gives buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. 

On expiry date, if option contracts are not utilized then only premium amount is at loss. Importers/ Exporters can hedge against foreign currency risk by purchasing a currency put or call. Currency options are derivatives based on underlying currency pairs. Risk includes interest rate differentials (IRD), market volatility, the time horizon for expiration, and the current price of the currency pair.

BENEFITS

1. Option limits the downside risk and may lose only the premium paid to buy the options, but have unlimited upside potential.

2. Options will hedge open positions which Exporter/ Importer can hold in the forex cash market.

KEY OPTION TERMINOLOGY

Premium – The upfront cost of purchasing a currency exchange option.

Strike Price – The strike (or exercise price) is the price at which the option holder has the right to buy or sell a currency.

Expiry Date – The trade’s expiry date is the last date on which the rights attached to an option may be exercised.

Exercise – The act of the option buyer notifying the seller that they intend to utilize the option contract.

Delivery Date – The date when the currency exchange will take place, if the option is exercised.

Mr. Bharat is a garment exporter. He gets a contract to supply 10,000 shirts to USA in the month of January 2025.The cost of making one shirt is Rs 83.50. He keeps a profit margin of 50 paisa. Thereby making the final cost per shirt as Rs 84. Remittance is expected in the month of February 2025.

The current rate (spot rate) is 84.00 and one month future currency is 84.20. If he books Forward or  future contract then he will get a profit of 20 paisa. In this case if dollar rupee goes above 84.20, he will not be able to take advantage of favorable market movement hence Mr. Bharat decides to use put option.

For February expiry, premium of 84.00 strike is 0.18 and premium level of 83.75 strike is 0.11

He can BUY either 84.00 PUT by paying 0.18 paise or 83.75 PUT by paying 0.11 paise

In First case he is protecting his profits and in second case he is protecting the cost of the product. Remember the option strike should be less than the current Forward Rate as the option premium is less as the strike goes down

There are two possibilities in feb 2025

1. USD INR rate is more than 84.20
2. USD INR Rate is less than 84.20

In the First Case, Mr Bharat wll forget his option and sell the dollar receivable at the Spot rate. Lets take two eamples

1. Spot rate is 84.50 - In this case he sells his dollars at 84.50 but ince he has paid 18 / 11 paise premium the net rate to him will be 84.32 / 84.39. Both these rates are more than the original rate of 84 or 84,20 (If forward booking was done)
2. Spot rate is 85.00 - In this case also  he gets much more rupees for his dollars eport money.

In the second case, Mr bharat will use the option and  also sells the dollar received at the spot rate. Lets again see two examples

1. Rate is 83.50 - Mr Bharat gets a profit of 0.50 / 0.25 from the exchange and he sells dollars with the bank. so he will get additional benefit of 32 paise (50 - 18) if put of 84.00 was bought and 39 paise (50 - 11 if put of 83.75 was bought.

Net rate in this case will be 83.50 + 0.32 / 0.39 which is more than the spot rate

    2. Rate is 83.00 - Again he gets a profit of 1.00 / 0.75 from exchange making it 0.82 / 0.89 paise net gain more than the spot rate

Remember in both cases Dollars are sold to the Bank and on Echange only Profits are booked or cost of premium is forgotten. Also if we receive the dollars before the due date, we should immediatly sell the puts we bought initially

As we can see from our examples, we can see that options are an alternative to forward Contract where we protect the downside Risk and keep our options open if the currency rate goes up. However we should not use options if rates are already very high and the chances of it going higher is less. We should use a mi of forwards (50 -60%) and options (40 - 50%) to opmimise our profits

If you want Prashanti Forex to design and execute such strategies for your company

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