Knock Outs

Purpose

Knock-out options have been designed to provide customers with a high level of foreign exchange protection at a lower cost than standard currency options, but without removing a company's ability to profit from favourable currency movements.

Description

A knock-out option provides a customer with protection against adverse currency movements in a similar way to a standard currency option. In addition to the normal option variables, the buyer also selects a knock-out price which is a level at which the option lapses and the buyer is left uncovered. If the knock-out price is reached before the option matures the buyer must then choose between remaining uncovered, dealing in the spot or forward markets or selecting new option protection. If the knock-out price is not reached, the option is settled at expiry in the usual way.

Knockout levels are usually set such that the option lapses when it is out of-the-money, i.e. when the spot price has moved in a direction favourable to the underlying exposure. The appropriate rate may depend upon the customer's currency forecasts or may be related to the relative premium cost of the option. The closer the knock-out level is to the current spot rate the cheaper the option. Generally knock-out levels are set at a point where the user will be happy to initiate spot/forward cover, or at a level just above/below important resistance/support levels.

Typical Use

A company wishing to gain cost-effective protection against unfavourable currency movements and who expects the spot rate will trend without significant correction

Exporter Example

Exposure

You are a Australian based exporter with USD10m in receipts due in three months. At that time you will need to buy AUD. The current spot price is USD 0.5700. The three month forward rate is USD 0.5710.

Market View

You are unsure of the future direction of the Australian dollar against the US dollar. You wish to protect yourself against an adverse currency movement but would like to gain from a depreciation in the AUD. You would be happy to deal in the spot market if the spot price reaches 0.5400.

Possible Solution

You purchase a knockout AUD Call option with a USD 0.5700 strike price and a USD 0.5400 knock-out price for a premium of USD150,000. This equates to 1.50% of the face value of the contract. In comparison a standard three month AUD Call with a USD 0.6500 strike price would cost significantly more at 1.80% or USD180,000.

Outcome
  1. If the spot price of the AUD should trade at USD 0.5400 (the knock-out rate) before the option matures, the option automatically lapses leaving you without cover. At this point you can deal in the spot market, cover in the forward market or select new option protection.
  2. If the AUD/USD exchange rate is above USD 0.5700 and the option is not knocked-out you will exercise the option. In this case your effective exchange will be equal to the strike price less the premium.
  3. If the AUD is between 0.5700 and 0.5400 you let the option lapse and buy AUD in the spot market.
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