By Sunil K. Parameswaran
A contact choice makes it possible for the holder to invest in the underlying asset at the workout value, if the spot value is greater. An Indian importer, worried that the US dollar (USD) might appreciate by the time he tends to make the scheduled payment, can invest in a contact choice.
The contact puts a cap on the exchange price. If the spot price at the time of the transaction is greater, then the contact will be exercised. Else, it will be permitted to expire, and the importer will obtain the dollars at the prevailing spot price. Thus, contact possibilities lock in a maximum obtain value for an importer who requirements foreign currency.
Currency movements
Exporters on the other hand will be worried about a depreciating USD, and consequently, would like to lock in a minimum sale value. They can do so by going lengthy in a place choice on the USD. If the spot price at the time of the transaction is decrease than the workout value of the choice, the place can be exercised, and the dollars can be sold at the workout value. Else the foreign currency can be sold at the spot price, which by assumption is greater. Thus, puts provide a floor or a minimum value.
A collar supplies each a cap as properly as a floor. A trader can sell a contact choice with an workout value X1 and invest in a place choice with a decrease workout value X2. If the spot price is above X1, the counterparty will workout the contact and the trader can provide the dollars at a price X1. If the spot price declines and goes under X2, the trader can workout the place, and lock in a sale value of X2. If the spot price remains among the upper and decrease limits, neither will the trader workout the place and nor will the counterparty workout the contact. Thus, the dollars can be sold at the prevailing spot price.
Call and place premium
For a offered set of parameters the greater the workout value the decrease the contact premium, and the decrease the workout value the decrease the place premium. Thus, in practice, X1 and X2, the upper and decrease bounds, can be selected such that the quantity received by promoting the contact is equal to what has to be paid to obtain the place. In such a circumstance, net investment is zero and such a technique is referred to as a zero-price collar.
An exporter can invest in a collar by promoting a contact and obtaining a place. An importer can sell a collar by obtaining the contact and promoting the place. In the latter case, if the upper ceiling is breached, the trader can workout the contact and obtain the foreign currency at the cap. However, if the spot price declines and goes under the floor, the counterparty will workout, and the trader will have to obtain the foreign currency at the floor.
Since a collar entails obtain of one choice and sale of an additional, net investment is decrease. A collar sets each an upper and a decrease limit. The decision an person tends to make would rely on how bullish or bearish one is.
The writer is CEO, Tarheel Consultancy Services