Options Trip

a case study by Gunter Dufey & Ian H. Giddy

(For Giddy's Internatonal Financial Management course)

Janet Rabson had labored for many years in the accounting department of a medium size construction company. Through hard work, intelligence and a bit of luck she worked her way up to the newly created Treasurer's job, a responsibility split off from those of the V.P. Finance and Controller. The company not only promoted her, but also agreed to pay for training, especially since the company began to look seriously at construction projects overseas.
A great deal of Janet's time was taken up by haggling with bankers, and she was determined not to be taken advantage of, especially when it came to using new financial instruments. Thus she readily accepted the invitation of the Royal Bank of Scotland who offered a two day seminar on options to be held in London.
The seminar, for which the bank hired an instructor from a U.S. business school, gave Janet lots of useful information about the use and abuse of options in corporate risk management. On the plane on the way home the flight attendants handed out the International Herald Tribune and Janet, eager to catch up on the business news, saw an article that caught her attention. "Oh, how timely," she thought; "Let's see whether we can't learn a trick or two from the clever Japanese!"

Article from International Herald Tribune

Options Trip Japanese Exporters
Price of "Zero-Cost" Dollar Tactic Was Lost Opportunity


TOKYO -- Japanese exporters lost out on the chance to make big profits when the dollar rose to 135 yen because they were forced to sell at much lower levels to cover currency option commitments, according to currency analysts.

What are called foreign exchange opportunity losses occurred in June, when the dollar rose above 127 yen on news of an unexpectedly small April U.S. trade deficit.

The rise triggered the exercising of dollar call options sold by exporters as part of a strategy called "zero-cost." The option holders required them to sell dollars below market prices.

"Japanese corporations lost the chance to sell dollars at higher levels, but real losses were probably few," said Tetsufumi Fujisawa, head option trader at Sumitomo Bank Ltd.

In a typical zero-cost option transaction to hedge against a falling dollar, an exporter buys a $10 million put option. This gives the exporter the right to sell dollars at a specified price, no matter how low the currency falls.

But the exporter must also sell a $30 million call option under this strategy. This option gives the other party, usually a bank, the right to buy dollars from the exporter, also at a predetermined price. This three-to-one ratio enables the party that sells the riskier put option to dispense with the premium that the buyer would normally pay, thus giving rise to the name "zero-cost."

Japanese exporting companies, especially car makers and electronics companies, which receive dollars from overseas sales, had been using zero-cost options heavily since February to hedge against a lower dollar, option traders said.

As long as the dollar was unchanged or falling, exporters could sell portions of their incoming dollars for yen at favorable prices.

Many Japanese exporters sold dollars aggressively after the release of good U.S. trade deficit numbers to keep the dollar from rising over the call option strike price, at which they would have to sell dollars cheaply, traders said.

"This strategy was quite successful until June, but in June a lot of the corporates got caught," said Arie Assayag, a currency options trader at Société Générale's Tokyo branch.

In June, dollar bullishness after a smaller-than-expected $10.3 billion April U.S. trade deficit overpowered sales of the currency by Japanese exporters.

The dollar, which traded around 125 yen on June 14, rose to close on June 22 above 127.50 yen for the first time in Tokyo in three months. It continued to soar and ended at the year's high for Tokyo of 135.15 yen on July 18.

Many exporters rushed to buy dollars in the spot market to cover option commitments.

This sudden rush for dollars helped add momentum to the currency's upward surge, traders said.

"When the dollar went up, a lot of people said, 'Hell, I want to change my mind,' but they couldn't," said an options specialist at a U.S. investment banking firm in Tokyo.

Japanese exporters "got a little cocky toward the end and probably ended up eroding some of the gains they had made on earlier transactions" in options, the specialist said.

Ironically, zero-cost options were originally designed by banks in part to induce Japanese corporations, which dislike paying premiums, to use options, traders said.

Many Japanese exporters calculate their break-even levels on a 125 yen dollar, so few companies actually lost money, traders said. With the dollar trading above 130 yen, exporters have been able to profit by selling dollars forward.

In addition, many companies had matched their call option commitments with dollar proceeds from overseas sales. Many exporters who were not matched evenly went to the currency swap market to borrow dollars owed on option commitments.

Other exporters hedged by buying dollars or straight-out call options to cover their positions, traders said.

"It's true that there were opportunity losses, but actual profits were much bigger," said Masao Kotani, vice president at Citibank's Tokyo branch.

Still, options traders said that zero-cost option trading, which until June accounted for 60 percent of the $6 billion to $10 billion monthly volume in the Tokyo over-the-counter corporate cash currency option market, declined sharply in July and August.

Japanese importers, seeing the possibility that the dollar may rise further, are starting to use zero-cost options to hedge against the currency's upside movement.
International Herald Tribune, August 16, 1988, p. 13.

"Hmm," Janet frowned, "what are they doing?! It doesn't make sense to me. I'd better draw some hockey sticks like we learned in the seminar! Then perhaps I can understand what's actually going on."
Ian H. Giddy, Professor of Finance
New York University Salomon Center • Stern School of Business
44 West 4th Street, New York 10012
Tel 212 998-0704 • Fax 212 995-4220

Go to Giddy's Web Portal • Contact Ian Giddy at igiddy@stern.nyu.edu