Option Types – Knock-In Options

Purpose

Knock-in options can be used to provide hedgers with risk profiles that are potentially more attractive that those available with vanilla options when they are looking to sell covered options as part of a hedging strategy.

Description

A knock-in option is an option that only comes into being when a pre-specified spot level is reached or “triggered.” Once the option comes into existence, it then has all the characteristics of a standard European-style vanilla option. It will also be treated at expiry in the same way and will be exercised if in-the-money or allowed to expire if out-of-the-money. Upon expiration, if the knock-in level has never traded during the option’s lifetime, it simply ceases to exist.

Typical Use in Hedging

  • Knock-in options are generally used in conjunction will standard options to construct more cost-effective hedging strategies.

Exporter Example

Exposure

Consider the case of an Australian based exporter with a USD 10,000,000 receipt due in six months’ time. At that time, they will need to buy AUD and sell the USD 10,000,000 they expect to receive. The current AUD/USD spot rate is 0.5700 and the six month forward rate is 0.5710.

Market View

The exporter is unsure of the future direction of AUD/USD, but expects it to trade in a reasonably narrow range. They wish to protect against an adverse currency movement, but would also like to gain from depreciation in the AUD/USD rate.

Possible Solution

The exporter could purchase a six-month vanilla AUD call/USD put in USD 10,000,000 with a 0.5750 strike price and sell a knock-in AUD put/USD call also with a strike price of USD 0.5750 and a knock-in level of USD 0.5400. This is a zero-cost strategy.

Outcome

  1. If the AUD/USD exchange rate is below 0.5750 at expiry, and during the life of the option AUD/USD has traded at 0.5400 to trigger the knock-in option into being, then the exporter’s AUD call/USD put option would be allowed to lapse, but their counterparty’s AUD put/USD call would be exercised against them, so the exporter would buy AUD and sell USD 10,000,000 at 0.5750.
  2. If the AUD/USD exchange rate is above 0.5750 at expiry, the exporter would exercise their AUD call/USD put option to allow them to buy AUD and sell their USD 10,000,000 at 0.5750, while their counterparty’s AUD put/USD call would expire worthless irrespective of whether or not 0.5400 had traded in AUD/USD during the knock-in option’s lifetime.
  3. If the AUD/USD exchange rate is below USD 0.5750 at expiry, and has not traded at USD 0.5400 during the life of the knock-in option, then both options lapse. The exporter is also free to sell their USD 10,000,000 and buy AUD at the more favourable prevailing AUD/USD market rate which would also be their effective rate since the hedge strategy was zero-cost at entry.

 

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