An exporter can buy a collar by selling a call and buying a put. An importer can sell a collar by buying the call and selling the put
By Sunil K. Parameswaran
A call option allows the holder to buy the underlying asset at the exercise price, if the spot price is higher. An Indian importer, worried that the US dollar (USD) may appreciate by the time he makes the scheduled payment, can buy a call option.
The call puts a cap on the exchange rate. If the spot rate at the time of the transaction is higher, then the call will be exercised. Else, it will be allowed to expire, and the importer will acquire the dollars at the prevailing spot rate. Thus, call options lock in a maximum purchase price for an importer who needs foreign currency.
Exporters on the other hand will be worried about a depreciating USD, and consequently, would like to lock in a minimum sale price. They can do so by going long in a put option on the USD. If the spot rate at the time of the transaction is lower than the exercise price of the option, the put can be exercised, and the dollars can be sold at the exercise price. Else the foreign currency can be sold at the spot rate, which by assumption is higher. Thus, puts provide a floor or a minimum price.
A collar provides both a cap as well as a floor. A trader can sell a call option with an exercise price X1 and buy a put option with a lower exercise price X2. If the spot rate is above X1, the counterparty will exercise the call and the trader can deliver the dollars at a rate X1. If the spot rate declines and goes below X2, the trader can exercise the put, and lock in a sale price of X2. If the spot rate remains between the upper and lower limits, neither will the trader exercise the put and nor will the counterparty exercise the call. Thus, the dollars can be sold at the prevailing spot rate.
Call and put premium
For a given set of parameters the higher the exercise price the lower the call premium, and the lower the exercise price the lower the put premium. Thus, in practice, X1 and X2, the upper and lower bounds, can be chosen such that the amount received by selling the call is equal to what has to be paid to acquire the put. In such a situation, net investment is zero and such a strategy is referred to as a zero-cost collar.
An exporter can buy a collar by selling a call and buying a put. An importer can sell a collar by buying the call and selling the put. In the latter case, if the upper ceiling is breached, the trader can exercise the call and acquire the foreign currency at the cap. However, if the spot rate declines and goes below the floor, the counterparty will exercise, and the trader will have to acquire the foreign currency at the floor.
Since a collar entails purchase of one option and sale of another, net investment is lower. A collar sets both an upper and a lower limit. The choice an individual makes would depend on how bullish or bearish one is.
The writer is CEO, Tarheel Consultancy Services