Question

You have covered a foreign exchange debt using a call. Show graphically how the call limits the potential losses created by high exchange rates, without eliminating the potential gains from low rates.

Answer 1

The call option on currecny allows us to buy a foreign currency at a specified rate. For example if one has to buy US dollars for Euro, one can enter a call option to buy USD. Let the strike price be $1.30 per Euro. Any rate higher than this, the call option shall be exercised and the highest effective rate shall be $1.30. At any rate lower than this at expiration, the call needs not be exercised as it is the right and not an obligation to exercise a call.

We shall have payoff as below:

Rate at Expiration	Payoff	Effective rate
$                        1.20	$    (0.10)	$               1.20
$                        1.21	$    (0.09)	$               1.21
$                        1.22	$    (0.08)	$               1.22
$                        1.23	$    (0.07)	$               1.23
$                        1.24	$    (0.06)	$               1.24
$                        1.25	$    (0.05)	$               1.25
$                        1.26	$    (0.04)	$               1.26
$                        1.27	$    (0.03)	$               1.27
$                        1.28	$    (0.02)	$               1.28
$                        1.29	$    (0.01)	$               1.29
$                        1.30	$           -	$               1.30
$                        1.31	$           -	$               1.30
$                        1.32	$           -	$               1.30
$                        1.33	$           -	$               1.30
$                        1.34	$           -	$               1.30
$                        1.35	$           -	$               1.30
$                        1.36	$           -	$               1.30
$                        1.37	$           -	$               1.30
$                        1.38	$           -	$               1.30

This can be represented graphically as: