To Exercise or Not to Exercise Call Options
Having a foreign exchange call option means that you have the right to buy foreign currency. If you represent a multinational company, the company may have account payables in foreign currency, which would motivate the company to hedge against foreign exchange risk.
In this case, the exchange rate risk is a possible appreciation of the foreign currency. If you are a speculator, you plan to buy foreign currency at a cheaper price on the option contract and sell it at a higher price in the future spot market. In this case, you’d like to take advantage of a possible appreciation of the foreign currency.
As an MNC or a speculator, a call option locks you in a maximum price to be paid for a currency in the future. The future spot market is your benchmark for exercising the call option or not. If the spot exchange rate is larger than the exercise price (the exchange rate on the options contract), the holder of a call option exercises the option to buy the currency.
If the spot rate is lower than the exercise price, the holder lets the call option expire without exercising it.
For example, a U.S. firm imports cheese from a Swiss firm for SFR100,000, which has to be paid in Swiss francs upon delivery in March. In this case, the American importer has future payables in Swiss francs and faces the risk of appreciation of this currency.
Suppose the American importer buys a call option with a premium of $0.0125 per Swiss franc and the exercise price of $1.10. The U.S. firm pays a total premium of $1,250 upfront ($0.0125 x 100,000) and if it decides to exercise the option, it will buy SFR100,000 for $110,000 (SFR100,000 x $1.10).
If the Swiss franc appreciates over the strike price during the contract period, the U.S. firm will exercise the call option and buy Swiss francs cheaper on the call option. For example, if the spot rate is higher than $1.10 (the exercise price), for example $1.13, the U.S. importer will exercise the call option and buy Swiss francs on the option contract.
However, if the spot rate is $1.06 (lower than the exercise rate), the U.S. firm will let the option contract expire and buy Swiss francs in the spot market, paying only $106,000 (SFR100,000 x $1.06).
Foreign exchange options can be used in currency speculations, when market participants expect changes in the exchange rate in the future. As indicated before, speculation implies profiting from buying low and selling high.
Therefore, if a speculator buys a call option, say, in pesos, he must be expecting an appreciation of the peso in the future spot market. His plans are to buy pesos at a lower price on a call option and sell them at a higher price at the future spot market.
Suppose you expect an appreciation in the peso in a month. You buy a call option for MXN1,000,000 with a premium of $0.0014 per unit and a strike price of $0.083. The expiration date is a month from now. Your decision whether to exercise your option depends on the dollar–Mexican peso rate that you observe in the spot market.
When the future spot rate exceeds the exercise price, you’ll exercise the call option. Suppose the spot rate one month from now is $0.086. Your per-unit revenue is $0.003 ($0.086 – $0.083) because you’ll buy pesos on the option contract for $0.083 and sell them at the spot market for $0.086. Your total revenue from this transaction is $3,000 (MXN1,000,000 x 0.003).
Now consider a situation where the future spot rate is lower than the exercise price, for example, $0.080. In this case, you wouldn’t exercise the call option, because your per-unit revenue from buying pesos on a call option and selling them at the future spot market is negative ($0.080 – $0.083 = –$0.003). Now you let the call option expire.
Note that until now you consider your revenue from buying currency on a call option and selling it at the future spot market. Your payoff or profit is different than your revenue. Starting when you buy the option until and including the time of your decision to exercise or not exercise, the premium remain a sunk cost, an already paid and unrecoverable cost.
However, when you consider your payoff or profit, you need to consider the premium. In a call option, your profit/loss is indicated by:
profit/loss = selling price – buying price
In the previous formula, the selling price implies the spot exchange rate. The buying price consists of the addition of the exercise price and the premium. In other words:
profit/loss = spot exchange rate – (exercise price + premium)
Consider the case when you buy a call option for MXN1,000,000 with a premium of $0.0014 per unit and a strike price of $0.083. You exercise your option when the current spot rate is $0.086. In this case, your per-unit profit is:
profit/loss = $0.086 – $0.083 – $0.0014 = +$0.0016
Considering the fact that you buy MXN1,000,000, your total profit is $1,600 (MXN1,000,000 x $0.0016).