A wider range offers more opportunity to gain from favorable currency movements but

simultaneously increases exposure to losses from currency depreciation. Conversely, a

tighter range reduces both a potential for gains and for losses. Should spot be below the put
strike at maturity, the intrinsic value of the purchased put option will offset losses on the
exposure beyond the strike. If spot is above the call strike, the intrinsic value of the call
option will offset gains beyond the strike of the call. If spot falls within the range at maturity,
the receivable can be translated at the spot

Your company protects against a strengthening euro by executing a range forward contract
with a 1.26 floor and 1.30
cap expiring on June 29. If at expiry the EUR spot is:
Above 1.30, you purchase EUR at 1.30
Below 1.26, you purchase EUR at 1.26
In between this range, you purchase EUR at the prevailing market rate

Accounting Horizons
June 2002, Vol. 16, No. 2, pp. 95-108

Alternative Approaches to Testing Hedge Effectiveness under SFAS No. 133

Pricing and hedging capped options

1. Phelim P. Boyle,

2. Stuart M. Turnbull

Article first published online: 25 AUG 2006

In answering this question, the first thing to note is that the prices of call options vary depending upon the
strike price. The lower the strike price, the more expensive the call option. This makes sense because a
call option gives the holder the right to acquire the underlying futures contract at the strike price. A lower
strike price means the option holder can acquire the futures at a cheaper price, but the option buyer must
pay for this privilege by paying more money for the option. The two almost exactly offset each other, so
there are no quick and riskless profits that can be made. This is ensured by professional arbitrage within
the trading pit.

Part of the answer to selecting the option strike price is determining how much the trader wants to spend
and risk because the most an option buyer can lose is the cost of the option plus transaction and other
fees. For example, if a trader wanted to spend no more than $500 on a July cocoa call option, then the
750 strike option would be excluded from the list because it is too expensive.

The second factor in choosing an option's strike price is determining how much the price of the underlying
futures contract will move by the time the option expires. For example, the July cocoa options expire in
early June. If a trader thinks it's unlikely that July cocoa futures will rally to over $900 by this time, then
they should not buy a call option with a strike price of 900 or higher.

Let's say a trader expects July cocoa to rise to 885 by the time the options expire. The 800 call option will
be worth $850 at expiration, generating a net profit of $520 ($850 - $330 = $520) or a 158% return. The
850 call option will be worth $350 at expiration, generating a net profit of $170 ($350 - $180 = $170) or a
94% return. In this case, the option with the 800 strike price provides the better investment. The results
will, of course, vary depending upon the futures price that is expected. For example, if July cocoa is
expected to reach $935 by option expiration, then the rate of return on the 800 call option is 309% and
372% on the 850 call option.

Choosing the best strike price often involves a trade-off between these two factors. The option that
provides the better return on investment, if prices rise, is also the more expensive to purchase. The trader
must balance risk (or cost of the option) with potential return in this regard. Selecting the proper strike
price is no different than any other investment decision. In the cocoa example, there is no clear choice
between the 800 and 850 call option, although the 800 call is probably the better investment over most
bullish scenarios.

As a general rule of thumb, a near- or at-the-money option, an option whose strike price is close to the
price of the underlying futures contract, is usually a good choice. In contrast, beginners should be
cautious about buying options that are deeply out-of-the money. Despite its appeal, such a strategy rarely
leads to consistent profitability, and this is the topic of Buying Options Part III in the next column.