Aug 23 2018

USDINR Ideas – Options are the only alternative left – 23Aug18

In a research article dated 21 May 2018, I had highlighted how vanilla options can be used effectively to hedge currency risk in volatile and uncertain times. Using a vanilla option was an efficient alternative then; now it is no more an alternative – it is THE ONLY ALTERNATIVE left.

 

Let us understand how a vanilla option can manage forex risk in such chaotic times:

For an exporter whose receivable is due in 1 month – he is in a sweet spot since rupee has moved in his favour

Spot USDINR: 70.10

1 month USDINR forward rate: 70.355

A USD Put (Right to sell dollars) at 70.355 will cost him 55 paise

After 1 month, if USDINR gains above 70.355, he will let the option lapse and use the market rate to encash. For example, if USDINR is at 71.25 after a month, he will get 71.25 (net rate 71.25 – 0.55 = 70.70)

After 1 month, if USDINR weakens below 70.355, he will exercise the option and use it to encash. For example, if USDINR is at 69.25 after a month, he will get 70.355 (net rate 70.355 – 0.55 = 69.805)

Worst case rate is 69.805 while best case rate is complete benefit of rupee depreciation (no restriction on dollar upside)

 

For an importer whose payment is due in 1 month – his costing and bottom-lines have gone for a toss due to excessive rupee weakening

Spot USDINR: 70.10

1 months USDINR forward rate: 70.355

A USD Call (Right to buy dollars) at 70.355 will cost him 55 paise

After 1 month, if USDINR gains above 70.355, he will exercise the option and use it to pay. For example, if USDINR is at 71.25 after a month, he will pay at 70.355 (net rate 70.355 + 0.55 = 70.905)

After 1 month, if USDINR weakens below 70.355, he will let the option lapse and use the market rate to pay. For example, if USDINR is at 69.25 after a month, he will pay at 69.25 (net rate 69.25 + 0.55 = 69.80)

Worst case rate is 70.905 while best case rate is absolute benefit of rupee appreciation (no limitation on dollar downside)

 

In either of the cases above, our worst case rate is defined (cost/loss minimized) while our best case rate is left to the market (ride the market gains).

 

Isn’t this what we actually want!!