Protecting Import Cost with Call Options

Call options are a type of derivative contract that gives the holder the
right, but not the obligation, to purchase a specified amount of Currency at a predetermined price, known as the “strike price” of the option. 

If the Currency rate rises above the option’s strike price, the option holder can exercise their option, buying at the strike price and selling at the higher market price in order to lock in a profit. If the market price does not rise above the strike price during that period, the options expire worthless

·Premium – The upfront cost of purchasing a currency exchange option. Premium is paid by the buyer in cash and paid out to the seller in cash on T+1 day. Until the buyer pays in the premium, the premium due is deducted from the available Liquid Net Worth on a real time basis

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.( Thursday).

·Hedging: In any asset class, is ultimately a strategy to decrease or transfer risk in order to protect one’s portfolio or business from uncertainty in prices. In case of hedging in the foreign exchange market, a participant who is entering a trade with the intention of protecting the existing position from an unexpected currency move, is said to have created a forex hedge.

Trading Hour: The trading hours are from 9 a.m. to 5.00 p.m. on all working days from Monday to Friday and the contract Size is US$ 1,000.

M/s Bharat Steels gets a contract to supply 1000 tons steel in India. He has to import it from Japan. The cost of steel is $ 600 per ton. His total exposure is $ 600,000. The current rate is 84.00 which is spot rate and future rate is 84.15.

 Costing of steels in domestic country comes to around 84.35, keeping a profit margin of 20 paisa.

The current rate (spot rate) is 74.00 and one month future currency is 84.15. If he books Forward Contract or buy future contract then he will get a profit of (84.35 - 84.15) 20 paisa. In this case if dollar rupee goes below 84.15, he will not be able to take advantage of favorable market movement hence Mr. Bharat decides to use call option to mitigate the risk. 

Now he has to select a strike price he should either select 84.00 (Current Spot) or 84.25 (10 paise lower than the sell price). The premium of first Strike is 20 paise so his total maximum cost is 84.20 while the option price of strike price of 84.25 is 15 paise so his total cost is 84.40. Although this is more than his selling price in india but he is only protecting the loss sise while he has a view that the premium is  lower so his initial outflow is low

There are two possibilities

1. The rate is more than 84 and 84.15 - He will sell the option and buy dollar in cash from the bank. As the Rate has moved up there will be a profit in option which will reduce his cost of import payment

2. The rate falls below 84.00 - he will not do anything with option and forget the premium he paid. Its just like insurance going unclaimed. but in this case he is benefitted from the rate fall. consider a situation rate going down to 83.50. He gains 50 paise by just paying a small premium

Buying call is an alternative with the Importer to protect the upside movemnt of rate while  keeping the option open for downside profits

We recommend using such options to be used for 20 to30% of your import payables.

In case you want our help in designing such strategies, you can contact us on +91 99300 93014 or just write to [email protected]