How to Calculate Domestic Interest Rate for FX Options

by Walter Johnson

Buying currency options is an important aspect of conducting international business. The problem is that buying supplies in one country means you normally use that currency to buy. If that currency appreciates, then you are paying more for your supplies than your competitors who might be buying from elsewhere. Therefore, firms buy options that permit them to dump a currency if it gets too high, while buying lots of a needed currency at a favorable rate.

1. Decide where your foreign currency must be in order for you to get worried. If you are buying supplies in Brazilian reals, and there is a threat that the central bank will raise rates, then you must be clear which rate will be too much. In other words, which rate will make buying suppliers in Brazil economically irrational. This is the central issue.

2. Use regression. Regression software is the only reliable method of doing this. This is because the only thing you are concerned about is what shift in the dollar, the domestic currency, will cause a shift in the real.

3. Enter the data of the daily shifting of the real over the last five years. This can seem daunting, but the Brazilian central bank, or even your own local bank, might have that data at their fingertips and can be sent to you as a single data package. Sometimes brokers and universities will also have this data to be sent as an email attachment.

4. Enter the data of the same thing for the dollar. These are your only two major variables. That is, how the dollar changes affect the real. Since the dollar is not necessarily the only thing that shifts the real, you need to control for everything else. Therefore, you will also enter data for the yuan, euro, ruble, peso and the yen. Entering these will control for their effects on the real, leaving just the effect of the dollar.

5. Interpret your findings. Each currency on your regression analysis will be given a so-called p score. This shows how significant each currency is in manipulating the real. What you care about is the dollar, that is, the domestic currency. You will then have the precise level of impact on the real exclusively from motions of the dollar.

6. Figure out how a change in the real will affect the change in the dollar. This is the main question, and now you have the answer. If, for example, your regression shows that a percentage point increase in the dollar means a 1.5 percent increase in the real, you know that if domestic rates rise 1 percent, the real will become expensive. Therefore, if the dollar is expected to rise soon, it might be a good idea to buy lots of reals now to avoid the issue altogether. The option will permit you to do this automatically.

7. Buy the option. Buying the option to sell reals will mean that, as the dollar increases, so will the real. The point is that the option permits these shifts in currency holdings automatically. You buy an option that says the firm will dump a certain amount of reals if its value goes over a set level. You then take this money and buy a currency that might be less expensive, and hence, easier to do business with.