A range forward option is a type of financial contract that allows you to hedge against currency fluctuations while retaining some upside potential. It is similar to a forward contract, but instead of locking in a specific exchange rate, it sets a range of acceptable rates within which the transaction will take place.
For example, suppose you are a U.S. company that expects to receive 100,000 euros from a European customer in three months. The current exchange rate is 1.2 USD/EUR, but you are worried that the euro might depreciate against the dollar in the next three months. You can use a range forward option to protect yourself from this risk.
You can enter into two derivative contracts: one long and one short. The long contract gives you the right to buy euros at the lowest rate within the range, and the short contract gives you the obligation to sell euros at the highest rate within the range. The combination of these two contracts has zero net cost, as they cancel each other out.
The range for your option is 1.18 USD/EUR and 1.22 USD/EUR. This means that if the exchange rate at maturity is below 1.18 USD/EUR, you will buy euros at that rate; if it is between 1.18 USD/EUR and 1.22 USD/EUR, you will buy euros at the market rate; and if it is above 1.22 USD/EUR, you will sell euros at that rate.
By using this option, you can benefit from small changes in the exchange rate while limiting your exposure to large ones. You also have some flexibility in choosing when to exercise your option, depending on your expectations of future movements.
Basic Theory:
A range forward option is a financial derivative that allows the holder to benefit from favorable currency movements within a specified range while protecting against adverse movements. Unlike a traditional forward contract, which locks in a fixed exchange rate, a range forward option establishes both an upper and lower limit, known as the range.
Buyer’s Perspective:
- The buyer (holder) of a range forward option pays a premium to the seller.
- The buyer has the right, but not the obligation, to exchange a specified amount of currency within a predetermined range.
- This provides flexibility, allowing the buyer to benefit from favorable movements within the range while having protection against unfavorable movements.
Seller’s Perspective:
- The seller (writer) of a range forward option receives the premium from the buyer.
- The seller is obligated to exchange the currency if the buyer chooses to exercise the option.
Procedures in Excel:
- Set Up the Excel Sheet:
- Create a table with columns for Spot Rate, Premium Paid, Range Upper Limit, and Range Lower Limit.
- Enter the necessary values for each column.
- Calculate Payoff at Expiry:
- Use Excel formulas to calculate the payoff at expiry based on the spot rate at that time.
- The payoff is typically calculated as the difference between the spot rate and the strike rate, subject to the specified range.
- Visualize Payoff Profile:
- Create a line chart to visualize the payoff profile at different spot rates within the range.
Comprehensive Example:
Consider a scenario where a company buys a range forward option for EUR/USD.
- Premium Paid: $10,000
- Range Upper Limit: 1.15
- Range Lower Limit: 1.10
Calculation:
Payoff = Max(Min(Spot Rate - Lower Limit, Upper Limit - Spot Rate), 0)
Payoff = Max(Min(1.12 - 1.10, 1.15 - 1.12), 0)
Payoff = Max(Min(0.02, 0.03), 0)
Payoff = Max(0.02, 0) = 0.02
Result:
The payoff at expiry would be $0.02 per unit of currency.
Other Approaches:
- Excel Solver:
- Use Excel Solver to optimize the premium and range limits for a desired risk-reward profile.
- Monte Carlo Simulation:
- Implement a Monte Carlo simulation in Excel to model various spot rate scenarios and assess the option’s performance under different market conditions.
