Knock Ins

Purpose

Knock-in options have been designed to provide customers with potentially more attractive pay-off (when they are looking to sell options as part of a hedging strategy), than they could generate by selling standard options.

Description

A knock-in option is an option that only comes into being when a pre-specified spot level is reached. Once the option comes into existence it has all the characteristics of a standard option and will be settled at expiry in the usual way ie. if it is in-the-money it will be exercised and if it is out-of-the-money it will lapse. If the knock-in level is not reached before the option matures the option will not exist.

Typical Use

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

Exporter Example

Exposure

You are a Australian based exporter with a USD10m receipt due in six months. At that time you will need to buy AUD. The current spot price is USD 0.5700 and the six month forward price is USD 0.5710.

Market View

You are unsure of the future direction of the Australian Dollar against the US dollar but you expect it to trade in a reasonably narrow range. You wish to protect yourself against an adverse currency movement but would like to gain from a depreciation in the AUD.

Possible Solution

You purchase a standard AUD call with a USD 0.5700 strike price and sell a knock-in AUD put also with a strike price of USD 0.5700 and a knock-in level of USD 0.5400. This is a zero cost strategy.

Outcome
  • If the AUD/USD exchange rate is below USD 0.5700 at expiry, and during the life of the option the market has traded at USD 0.5400 so that the knock-in option has come into being, then the bank would exercise its option and you would deal at USD 0.5700.
  • If the AUD/USD exchange rate is above USD 0.5700 you would exercise the AUD call option.
  • If the AUD/USD exchange rate is below USD 0.5700 at expiry, and has not traded at USD 0.5400 during the life of the option, then both options lapse and you deal at the market rate.
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