Creating and Pricing Hybrid Foreign Currency Options

Abstract

M For more than ten years, foreign currency markets have been characterized by wide price changes. This high volatility of exchange rates has exposed corporate treasurers and international investors to a significant level of currency risk. Currency options markets have developed to provide new means of dealing with this growing risk. The purchaser of a foreign currency call (put) option has the right, but not the obligation, to buy (sell) a given amount of a foreign currency at a predetermined (strike) price at anytime on or before maturity date for an American option, or only at maturity for a European option. Currency options have been the subject of considerable professional and academic interest as well.1 Indeed, these are traded on several security exchanges throughout the world. A sizable over-the-counter market has also developed, offering a variety of specialized currency options. Among such specialized options are the so-called hybrid foreign currency options. These hybrid foreign currency options are based on some use of the put/call parity relation. For example, the exporting corporation buys a put and simultaneously sells a call from the bank so that the overall cost is less than the cost of a straight put, but then the exporter loses any potential gain from an appreciation of the foreign currency above the strike price of the call. Currency risk management has thus become a delicate compromise between flexibility, protection, and cost. The achievement of such a trade-off amounts to tailoring an instrument which perfectly matches the needs of the investor, conditional on his anticipations. Banks world-wide have been quite successful in marketing those hybrids, although theoretically they can be replicated by combinations of instruments traded on organized markets. A typical hybrid like the Cylinder We are grateful to the anonymous referees and Hans Stoll, Associate Editor, for their insightful comments. The usual caveat applies.