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Currency Bull Spread using Call Options:

A Currency Bull Spread with call option is constructed by buying a call option for that underlying currency at a particular strike (exercise) price* and simultaneously selling another call option for the same underlying currency at a higher strike price in a bullish market where the investors expect the currency to appreciate.

Assuming Rs to be the local currency and USD to be the foreign currency in a bullish market where the foreign currency i.e. the USD is anticipated to appreciate (there by causing the Rupee to depreciate- more Rupees required to buy $1), let us take an example to clarify the concept of Currency Bull Spread with call option:

Suppose that an investor A decides to use the Currency Bull Spread with call option. He therefore buys a call option with an exercise price of Rs.30 and at a premium of Rs.2.00.That is he buys the right (but is not obligated) to buy one dollar at Rs.30 (exercise price) in a bullish market anticipating the foreign currency to rise in future, and the price he pays to buy this right is Rs.2.00 (the premium). Secondly, he decides to sell a call option that has a strike price of Rs.35 and at the premium of Rs.1.00.Say, the exchange rate of Rs in terms of US$ is Rs.28/US$ when investor A decides to buy and sell the two different options.

The three different case scenarios are as under:

CASE I- when the dollar appreciates to Rs.38/$ in the near future:

Let us say that when the exchange rate is Rs.28/US$, the investor decides to buy a call option with an exercise price of Rs.30/$ paying a premium of Rs.2.00 and at the same time he decides to write a call option for an exercise price of Rs.35/$ with a premium of Rs.1.00. Now when the dollar appreciates to Rs.38/$, the investor executes the following steps:

He excercises the first option by buying the dollar at the exercise price of Rs.30/$.

Secondly, he sells the dollars he just bought at Rs.35/$ as the buyer of the second call option would exercise his right to purchase the dollar at Rs.35.

Following are the per dollar cash flows that would occur:: -(Rs.2.00); -(Rs 30.00); +(Rs 1.00); +(Rs 35.00); --------------; +(Rs.4.00)

Thus the investor A would make a profit of Rs.4 per dollar he buys and sells under this scenario.

CASE II- when the dollar appreciates to Rs.34/$ in the near future

Now when the dollar appreciates to Rs.34/$, the investor executes the following steps:

He exercises the first option by buying the dollar at the exercise price of Rs.30/$.

Secondly, he does not sell the dollars he just bought at Rs.35/$ as the buyer of the second call option does not exercise his right to purchase the dollar at Rs.35 and rather purchases it at a lower cost of Rs.34/$ from the market. The investor A thus sells the dollar (to any other interested investor in the market) he bought at the prevailing market price of Rs.34/$.

Following are the per dollar cash flows that would occur:: -(Rs.2.00) premium paid by investor A for buying the option; -(Rs 30.00) investor A exercises his option; +(Rs 1.00) premium paid by investor B for buying the option; +(Rs.34.00) investor A sells dollar in market; --------------; +(Rs.3.00)

Thus the investor A would makes a profit of Rs.3 per dollar he buys and sells under this scenario.

CASE III- when the dollar unexpectedly depreciates to Rs.25/$ in the near future

Now when the dollar depreciates to Rs.25/$, the investor executes the following steps:

The investor does not exercise the first option of buying the dollar at the exercise price of Rs.30/$ and rather buys the dollar at the prevailing market price.

Similarly, the buyer of the second call option also does not exercise his right to purchase the dollar at Rs.35 and rather purchases it at a lower cost of Rs.25/$ from the market.

Following are the per dollar cash flows that would occur for investor A:: -(Rs.2.00) premium paid by investor A for buying the option; +(Rs 1.00) premium paid by investor B for buying the option; --------------; -(Rs.1.00)