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Options Types - Average Rate Options
PurposeAn average rate option has been designed to provide protection against movements in the average exchange rate over a given period.
Description There are two types of Average Rate Options:- Average Spot Rate Option
- Average Strike Rate Option
Average Spot Rate OptionsYou select price, expiry date and averaging dates. The averaging dates can be as frequent as required and need not to be at regular intervals. Similarly, the averaging amounts do not have to be equal. Funds are not exchanged until the final value date, at which time you receive the difference between the weighted average rate over the given period and the agreed strike price if the option is in the money.
Average Strike Rate OptionYou only select the expiry date, averaging dates and amounts. On the expiry date the weighted average rate becomes the strike price of the option. If this average rate/strike price is in the money at maturity, you receive the difference between the average rate/strike price and the spot rate at that time.
Typical Uses- A company, with periodic payments or receivables wishing to gain trend protection against unfavourable currency movements (Average Spot Rate Option).
- A company with an invoiced cost for materials based on the average of spot exchange rates over a defined period (Average Spot Rate Option).
- A company required to translate profits at average exchange rates on balance dates (Average Strike Rate Option).
Average Strike Rate Option Example
ExposureYou are an United Kingdom subsidiary of a foreign company which must, at the end of each year, translate profits at an average exchange rate. The required averaging dates are the end of each month. In order to repatriate the profits in one year you will need to sell GBP. In this example the current spot price is 0.5700 and the one year forward rate is 0.5750.
Market ViewYou are unsure of the future direction of the GBP. You want to protect yourself against an adverse currency movement but would like to benefit from any appreciation in the GBP.
Possible SolutionYou purchase an GBP Put Average Strike Rate Option with averaging dates at the end of each month. This would cost 2.70% of the USD amount
Outcome- If the average rate at year end is above the spot rate at expiry you exercise the option and the bank will pay the difference between the average rate (the rate at which you have translated your profits) and the spot price (the rate at which you can deal in the market at that time).
- If the average rate is below the spot price at expiry the option is allowed to lapse as you have dealt at more advantageous average rates in the spot market.
Average Spot Rate Option Example
ExposureYou are an United Kingdom company that exports USD 1 million worth of goods to the US each month. You want to protect your receivables over the next 12 months. In this example the current spot price is 0.5700.
Market ViewYou are unsure of the future direction of the GBP. You want to protect yourself against adverse currency movements but would like to benefit from any appreciation in the GBP.
Possible SolutionYou purchase an GBP call Average Spot Rate Option with a strike of 0.5700 and averaging dates at the end of each month. The agreed source for the average rate is the 11.00am daily exchange rate recorded by the Bank of England on Reuters page HSRA. This option will cost 1.85% of the USD amount.
During the period, on each averaging date, you simply sell the US dollars you receive in the spot market for British pounds. By dealing as close to 4 p.m. as possible you can ensure that the average rate you effectively deal at over the year is very close to the average rate used to settle the Average Spot Rate Option.
OutcomeAt the end of the period you will have effectively dealt at the average rate for the period.
1. If the average rate for the period is greater than 0.5700 you will exercise your option and your bank will pay you the difference between the average rate and the 0.5700 strike price. The amount you receive will effectively lower your actual dealing rates on average, to 0.5700 (provided the basis risk between the rate source for the averaging process and the rate you actually deal at each month is minimal).
2. If the average rate is below 0.5700 you would allow the option to lapse. In this case you will have benefited from the more advantageous averaging rate over the period in your monthly dealings.
Advantages - Protection from adverse movements in exchange rates coupled with the flexibility to take advantage of favourable movements if they occur.
- Structures tailored to your requirements as to strike price, averaging dates, expiry date and amount to be averaged at each date.
- Cost effective relative to a standard option.
- Simplifies exposure management. Changes to payments need not
cause changes to the option.
Disadvantages- Premium Payable up-front.
- Net settlement occurs only at end and thereby not matching cash
flows. Basis risk between settlement rate (a mid point) and actual dealing rate.
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