Using Options to Hedge Bids.

Using Options to Hedge Bids.

Until recently, GE, or any company that bid on a contract denominated in a foreign currency and was not assured of success, would be unable to resolve its foreign exchange risk dilemma. The advent of currency options has changed all that. Specifically, the solution to managing its currency risk in this case is for GE, at the time of its bid, to purchase an option to sell €10 million on December 31. For example, suppose that on January 1, GE can buy for $100,000 the right to sell Citigroup €10 million on December 31 at a price of $1.361/€. If it enters into this put option contract with Citigroup, GE will guarantee itself a minimum price ($13.61 million) should its bid be selected, while simultaneously ensuring that if it lost the bid, its loss would be limited to the price paid for the option contract (the premium of $100,000). Should the spot price of the euro on December 31 exceed $1.361, GE would let its option contract expire unexercised and convert the €10 million at the prevailing spot rate.

Instead of a straight put option, GE could use a futures put option. This would entail GE buying a put option on a December futures contract with the option expiring in April. If the put were in-the-money on April 1, GE would exercise it and receive a short position in a euro futures contract plus a cash amount equal to the strike price minus the December futures price as of April 1. Assuming it had won the bid, GE would hold on to the December futures contract. If it had lost the bid, GE would pocket the cash and immediately close out its short futures position at no cost.

As we saw in Chapter 8, two types of options are available to manage exchange risk. A currency put option, such as the one appropriate to GE’s situation, gives the buyer the right, but not the obligation, to sell a specified number of foreign currency units to the option seller at a fixed dollar price, up to the option’s expiration date. Alternatively, a currency call option is the right, but not the obligation, to buy the foreign currency at a specified dollar price, up to the expiration date.

A call option is valuable, for example, when a firm has offered to buy a foreign asset, such as another firm, at a fixed foreign currency price but is uncertain whether its bid will be accepted. By buying a call option on the foreign currency, the firm can lock in a maximum dollar price for its tender offer, while limiting its downside risk to the call premium in the event its bid is rejected.

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