Currency options and operations

A futures hedge locks a rate; an option hedge sets a floor or a ceiling while leaving the upside open. For a client who is unsure whether the rupee will move for or against them, that difference is worth paying for. The exam tests the mechanics: what the premium means in rupees, which option an importer buys, how the payoff works out at the reference rate, and the operational rules around margins and limits.

The contract

USD/INR options have traded on NSE since October 2010; EUR/INR, GBP/INR and JPY/INR options were added later. All are European style, exercised only at expiry, and premium-settled in rupees. The specifications, as set by the exchange:

• Underlying: the USD/INR exchange rate; lot USD 1,000.
• Premium: quoted in rupees per dollar to four decimals, tick ₹0.0025. A premium of ₹0.4000 on one lot costs 0.40 × 1,000 = ₹400.
• Strikes: at intervals of ₹0.25, with a set number of in-the-money and out-of-the-money strikes around the at-the-money strike, added as the rate moves.
• Expiry: serial monthly contracts plus quarterly contracts, and weekly contracts, as specified. Last trading day and final settlement day are the same as for futures.
• Settlement: in-the-money options are exercised automatically at expiry and settled in cash at the RBI reference rate. Out-of-the-money options lapse.

Because premium is in rupees per dollar, converting it to money is the same arithmetic as futures: multiply by 1,000 per lot. A client who buys 100 lots of a call at ₹0.40 pays ₹40,000, and that is the maximum he can lose.

Payoffs and the hedger's choice

A call on USD/INR pays (reference rate − strike) × lot size if the rate ends above the strike, otherwise nothing. A put pays (strike − reference rate) × lot size if the rate ends below the strike. The buyer's break-even is strike plus premium for a call and strike minus premium for a put.

An importer has to buy dollars later and fears a higher rate, so he buys a call: it pays him exactly when dollars get expensive. An exporter fears a lower rate and buys a put. Consider an importer with USD 1,00,000 payable in two months, spot 84.00, who buys 100 lots of the 84.50 call at ₹0.40.

The call caps the importer's cost at 84.90 (strike plus premium) however high the dollar goes, while letting him benefit if the rupee strengthens. A futures hedge at 84.40 would have given 84.40 in both cases: cheaper in case A, worse in case B. That is the trade-off you must be able to explain to a client: the option costs a known premium for the right to walk away.

The exporter's put works the same way. Buying the 84.00 put at ₹0.35 guarantees a worst-case rate of 83.65 on her dollars; if the rate ends at 85.00 the put lapses and she sells at 85.00 less the premium, 84.65. Writing options is the opposite trade: a seller collects premium and takes on the obligation, with potentially large loss, which is why sellers pay margin and buyers do not.

Pricing links

Currency option premiums depend on the same factors as equity options: spot, strike, time, volatility and the two interest rates. The rupee and dollar rates enter together through the forward: an option on USD/INR is priced off the forward rate for its expiry, not off spot, so a call with a strike equal to spot is already slightly in the money in forward terms when the dollar is at a premium. Put-call parity holds in the forward form, which is the version to remember.

If the 84.50 call trades at 0.40 and the futures at 84.40 with one month to go, the 84.50 put should trade near 0.50: the strike is above the forward, so the put carries more intrinsic value in forward terms. A quoted pair that breaks this relationship is an arbitrage question in disguise.

Operations: margins, limits, orders

The operational rules for currency options and futures sit together in the exchange's and clearing corporation's bye-laws, with the numbers notified from time to time. The points the exam expects you to know:

• Margins: option buyers pay only the premium, settled T+1. Option writers pay SPAN initial margin plus extreme loss margin, collected upfront by the broker. Net option value is adjusted in the margin computation daily.
• Position limits: set at client, trading member and bank level as the higher of a percentage of open interest or a notional dollar amount, aggregated across futures and options on the same pair, as notified by SEBI and RBI. Positions above the RBI threshold must be backed by underlying exposure.
• Eligible participants: residents, and non-residents such as FPIs and NRIs within the limits and conditions RBI prescribes. The trading member must capture the client's category correctly because limits differ.
• Order types: limit, market, stop-loss, immediate-or-cancel; day and good-till-day orders; spread orders between two months. Client codes are mandatory on every order and modification after the fact attracts penalties.
• Contract notes and statements: issued by the next working day, with premium, brokerage, taxes and charges shown separately, the same as in the equity segment.
• Exercise: automatic for in-the-money contracts at expiry; no instruction from the client is needed. Settlement obligations are computed at the reference rate and paid or received on the final settlement day.

Where a specification could have changed since you studied, the safe wording in the exam and with a client is "as notified by SEBI and RBI" or "as specified by the exchange". The underlying logic of the chapter does not change: lot of 1,000, premium in rupees per dollar, European exercise, cash settlement at the reference rate.