Currency Range Forward: GE and Lufthansa
Why would GE accept a contract that limits its upside potential? In order to lower its cost of hedging its downside risk. The cost saving can be seen by recognizing that a currency collar can be created by simultaneously buying an out-of-the-money put option and selling an out-of-the-money call option of the same size. In effect, the purchase of the put option is financed by the sale of the call option. By selling off the upside potential with the call option, GE can reduce the cost of hedging its downside risk with the put option. The payoff profile of the combined put purchase and call sale, also known as a cylinder, is shown in Exhibit 10.10. By adjusting the strike prices such that the put premium just equals the call premium, you can always create a cylinder with a zero net cost, in which case you have a range forward. In this exhibit, it is assumed that the put premium at a strike price of $1.45 just equals the call premium at a strike price of $1.55.