Finance

Range Forwards and Ratio Range Forwards : Are They Useful

Range Forwards. Effective from September 19, 1996, corporates are allowed to freely book and cancel options. Banks have been permitted to offer risk reduction and cost-effective strategies such as ‘range forwards’ and ‘ratio range forwards’ to their customers. Both products, which are basically combinations of options, help the customer get a hedge on a cost-effective basis.

Range forwards involve simultaneous buying and selling of call or put options. For example, if an exporter expects to receive USD 1 million in 6 months’ time and decides to receive it as Yen and his break even is 105 Yen per dollar, he may buy a USD put/Yen option of USD 1 = Yen 105. (That is, he can sell dollar to the bank at this rate.)

For buying the put option, the exporter pays a premium of say USD 50,000. This is the cost of the option. If the dollar appreciates and on the due date, the rate is USD 1 = Yen 120, he will not exercise the option and prefer to receive the higher value in yen at the spot rate. On the other hand, if the Yen appreciates and the rate on the due date is USD 1 =Yen 100, he will exercise the option.

Suppose the exporter wishes to reduce the cost of option and is willing to limit his gains from possible appreciation of dollar. As an exporter he can write (i.e., sell) a USD call/Yen option to his bank for USD 1 million, say at a strike price of USD 1 = 110. Under this contract, the bank has the option to buy USD 1 million at the end of the sixth month. The customer can collect premium from the bank offering this option. If the premium received is USD 40,000, the cost of both the op-tions is USD 10,000 as against the previous cost of USD 10,000. If the option is written at the same premium as that paid on the put option, the cost to the exporter will be zero.

Let us say the exchange rate on the due date is USD 1 =Yen 120. The exporter will not exercise his option. But the bank will exercise its option to buy dollars at Yen 110. The customer will receive Yen 110 million from the bank for the export proceeds. On the other hand, if the exchange rate turns out to be Yen 100, the exporter will exercise his option and require the bank to pay him Yen 105 million against the remittance.

It would not be advantageous for the bank to exercise its call option at this price. Thus under the range option, the exporter gets protection from exchange fluctuation in the range of Yen 105-110. He protects himself against dollar falling in value below this range at the same time he forgoes the opportunity of gaining from the dollar appreciating beyond this range.

Thus, as against a simple option, in a range option the cost of hedging can be reduced, but the potential of gaining is also limited.

Ratio range forwards is a more flexible variation of the range forwards. It is a combination of simple straightforward option and range forward options. The main difference is that the amounts of the option bought and sold are different. The ratio of the two amounts can be so chosen as to bring down the net payment of premium even to zero.

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