Options Type - Average Rate Options

Purpose

An 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 Rate Option (sometimes called an Average Spot Rate Option)
  • Average Strike Rate Option

Average Rate Options

In addition to the normal option parameters needed to price a vanilla option, a customer who wishes to transact an average rate option also needs to select the averaging dates or periodicity and the time of the day that the rate is to be observed. Averaging dates can be as frequent as required and need not be at regular intervals.  The customer will also need to specify the weights of each averaging date, which can be unequal. These observations, weighted if necessary, will then be used to calculate the intrinsic value of the option. Funds are not exchanged until the final value date, at which time the buyer will receive the cash value of any positive difference between the weighted average rate observed over the given period and the option’s strike price.

Average Strike Rate Option

The customer selects the averaging dates, weighting amounts and the other option parameters. In addition, the customer can usually select a degree of “money-ness” to set the strike price at relative to the averaging observations made, with the most common being at-the-money-spot. On the expiry date for an at-the-money-spot average strike rate option, the weighted average spot rate becomes the strike price of the option. If this calculated strike price is in-the-money at expiration, the buyer will receive the cash difference between that strike price and the prevailing spot rate.

Typical Uses for Hedging

  • A company with periodic payments or receivables that wishes to hedge against unfavourable currency movements can use an Average Rate Option to simplify their hedging program.
  • A company that has an invoiced cost for materials based on the average of spot exchange rates over a defined period can also use an Average Rate Option as a hedge.
  • A company required to translate profits at average exchange rates on balance dates could use an Average Strike Rate Option to protect against their currency exposure.

Average Rate Option Example

Exposure

An Australian company that exports USD 1,000,000 worth of goods to the United States each month will want to protect the value of its AUD receivables over the next 12 months. In this example, the current spot price is 0.5700.

Market View

The company is unsure of the future direction of the AUD, but they want to protect against adverse currency movements and would like to benefit from any appreciation in the AUD.

Possible Solution

The company decides to purchase USD 12,000,000 of an AUD call/USD put Average Rate Option with a strike price of 0.5700 and averaging dates at the end of each month. The agreed source for the average exchange rate observations for AUD/USD is the 11:00am daily exchange rate recorded by the Bank of England on Reuters page HSRA. This option costs them 1.85% of the USD amount.

During the lifetime of the option, the company simply sells the USD 1,000,000 they receive from exports each month in the spot market for Australian Dollars on each month-end averaging date. By dealing as close to 11:00am as possible, they can ensure that the average rate they effectively deal at over the year is very close to the average rate that will ultimately be used to settle the Average Rate Option.

Outcome

At the end of the 12-month period, the company has effectively exchanged their USD receipts for AUD each month at the average month-end rate observed during that period.

1. If the average rate observed over the entire one year period is greater than the option’s 0.5700 strike price at expiration, the option has intrinsic value. The company’s counterparty will then pay them the cash difference between the average rate observed and the 0.5700 strike price. The amount received effectively lowers the company’s actual dealing rates on average to 0.5700 plus the premium paid expressed in pips, provided that the difference between the rate source for the averaging process and the rate they actually dealt at each month was minimal.

2. If the average rate is below 0.5700, the company would receive no value from the option. In this case, they will have benefited instead from having transacted at the more advantageous average rate seen over the one year period in their monthly dealings.

Advantages

  • Protection from adverse movements in exchange rates coupled with the flexibility to take advantage of favourable movements that occur.
  • Option is tailored to specific exposure requirements as to strike price, averaging dates, expiry date and amount to be averaged at each date.
  • More cost effective relative to a vanilla option.
  • Simplifies exposure management since just one option can cover multiple exposures.
  • Changes to payments need not cause changes to the option.

Disadvantages

  • Premium is payable up-front.
  • Net settlement occurs only at end of the year and therefore does not match specific cash flows.
  • Company has risk between the averaging observation rate (a mid point rate that cannot be dealt at) and their actual dealing rate.

Average Strike Rate Option Example

Exposure

Consider the example of an Australian subsidiary of a U.S.-based company which must translate profits into USD at the end of each year at an average AUD/USD exchange rate. The required averaging dates are the end of each month. In order to repatriate the profits in one year, this subsidiary will need to sell AUD and buy USD. In this example, the current AUD/USD spot price is 0.5700, and the one-year forward rate is 0.5750.

Market View

The subsidiary’s foreign exchange manager is unsure of the future direction of the AUD. They want to protect against an adverse currency movement but would also like to benefit from any appreciation in the AUD relative to the USD.

Possible Solution

They could purchase an AUD Put /USD Call Average Strike Rate Option expiring in one year’s time with averaging dates at the end of each month. This would cost 2.70% of the USD amount

Outcome

  1. If the average rate observed by expiry at year end is above the spot rate, the subsidiary’s counterparty will pay the difference between the average rate (the rate at which their profits have been translated) and the prevailing spot AUD/USD rate (the rate at which one can deal in the market at that time).  This gain will help offset losses incurred by translating profits in the spot market at month-end throughout the previous year.
  2. If the average rate at expiry is below the spot price, the option will have no cash value and the subsidiary will have dealt at more advantageous average rates in the spot market as they translated profits at month-end during the preceding year.

 

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