A V Rajwade: Think before you write an option

Their pricing and hedging is arguably one of the most complex subjects in the theory and models of financial economics

About six weeks ago, the Reserve Bank of India (RBI) made a change in the exchange regulations on currency options. The change now permits exporters and importers to write, that is, sell, call and put options on the foreign currency to the extent of the outstanding, unhedged exports and imports. This is a major departure from the age-old policy of allowing importers and exporters to enter into derivative contracts only for hedging commercial exposures. One is unable to understand the rationale behind the change.

The pricing and hedging of options is arguably one of the most complex subjects in the theory and models of financial economics. The standard model for calculating option prices and hedge percentages (Delta) is named after two of its three developers: Fisher Black and Myron Scholes. It is based on price changes in the market being random and therefore, the outcomes conforming to the bell-shaped "normal" distribution. Another crucial assumption of the Black-Scholes model is that the volatility of price changes is constant. Empirical evidence suggests these assumptions rarely hold good in the marketplace. One striking example: the so-called "volatility smile". The Black-Scholes model assumes identical volatility across different maturities; market prices display different implied volatilities for different maturities. In any case, even in theory, probability-based models work only when one is using the same model hundreds of times: While we all know that the probability of a head or tail coming on top on toss of an unbiased coin is 50 per cent, this tells us nothing about what the next toss or even the next 10 tosses will lead to! The Black-Scholes model can work, and that too, imperfectly, only when one is using the same model for pricing hundreds - if not thousands - of options.

This apart, the model requires Delta hedging: the Delta keeps changing with each change in the spot rate, the forward margin, the balance maturity and the price volatility. For exporters and importers writing options, the Delta is constant, namely the outstanding contractual export or import commitment.

Such technicalities apart, options are most comparable to another financial contract with which most of us are familiar: insurance. Writing options by exporters and importers against unhedged exposures is like permitting a car owner to write an insurance policy on somebody else's car and earn the premium - so long as his own car is uninsured! The writer gains only if his car has no accidents, and the claim under the policy he has written is less than the premium earned. The exporter/importer writing options will gain only if the exchange rate on maturity is within the strike rate +/- the premium. Can this be predicted? I cannot predict rates even 10 minutes ahead!

There is another problem: the fair price of an option. In the over-the-counter (OTC) market, the only published data available are volatilities for different maturities and the "25 Delta risk reversals" and "Strangles". How many exporters or importers, or even non-specialist bankers, know how to calculate option prices from the published data? An added problem is that the RBI is likely to introduce compulsory margins for counterparty credit risks, which the option writer will have to pay.

My advice to exporters and importers: If you want to use options for hedging, buy them, don't sell them; if you want to speculate, do it on an exchange where the pricing and margin requirements are transparent. Overall, think a hundred times before writing options in the OTC market.

Tata DoCoMo case
When DoCoMo, the Japanese telecom giant, invested in Tata Telecom a few years ago, the Indian promoter had written an option in favour of DoCoMo to buy its holdings at half the price at which the investment was made. This was in compliance with the then RBI regulations, which were subsequently changed and now ban any exit by a foreign investor at an assured price. The Tatas are willing to honour their commitment but are not being permitted to do so. The London Court of International Arbitration ruled in favour of DoCoMo, and the case is now before the Supreme Court. This case, as also the earlier ones involving tax claims on Vodafone and Cairn, would surely make any foreign direct investor (FDI) hesitate about coming to India. It is strange that we harass FDI investors - who make long-term commitments to the country, create employment, and pay taxes - but pamper portfolio investors, who pay no taxes here, create no employment and have no long-term commitment to the country!

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com