8.5 Index & Foreign Currency Options
Index options eliminate company-specific risk and allow institutional portfolio hedging. Settlement mechanics differ fundamentally from equity options because no physical shares exist.
Key FINRA Exam Takeaways
- Broad-based index options (e.g., S&P 500 SPX, OEX) track the general market and hedge systematic risk.
- Narrow-based index options track specific industry sectors (e.g., semiconductors, biotech).
- CASH SETTLEMENT: Index options settle in cash on the NEXT BUSINESS DAY (T+1); no physical shares are delivered.
- Cash Settlement Amount = (Strike Price vs. Closing Index Value) × $100 multiplier.
- Foreign Currency Options: Settle in US dollars; US exporters buy puts on foreign currencies, US importers buy calls.
Cash Settlement Mechanics
When an index option is exercised, the writer pays the holder cash equal to the intrinsic value multiplied by 100. If an SPX 5,000 Call is exercised when the index closes at 5,020, the writer delivers ($5,020 - $5,000) × 100 = $2,000 cash the next business day.
Hedging Currency Risk for Importers/Exporters
US Importer paying in foreign currency: Fears foreign currency appreciating -> Buys CALLS on foreign currency. US Exporter receiving foreign currency: Fears foreign currency depreciating -> Buys PUTS on foreign currency.
A US manufacturing firm contracts to sell heavy equipment to a German company, with payment of 1,000,000 Euros due upon delivery in 6 months. To hedge currency exchange risk, the US firm should: