Protective call
Also written Long call hedge · Buying protection with call · Importer call hedge
Buying a call option to hedge a foreign currency payable: it caps the purchase rate at strike plus premium, while leaving the importer free to benefit if the currency falls.
In plain language
An importer has to pay dollars next month. His fear is that the dollar rises before then.
He can buy USDINR futures. That locks the rate — and locks away the benefit if the dollar falls instead. The workbook puts it plainly: buying futures locks in the purchase price of USD for the company and does not allow the company to benefit from a decline in the USDINR.
A protective call keeps the protection and keeps the benefit. The importer buys a USDINR call option.
If the dollar rises, the call pays out and offsets the higher cost of buying dollars.
If the dollar falls, the call is worthless and he lets it expire. He buys his dollars in the market at the better rate, and the only thing he has lost is the premium already paid.
The workbook sums up the trade: the long call hedge allows the importer to lock in a maximum payable amount while still enjoying the benefits from a decline in the exchange rate.
His worst case is a known number: strike plus premium.
How it works
The workbook's case (Chapter 5, section 5.3.7.2, Buying Protection with call). XYZ Ltd is an importer and has to make a payment of USD 100,000 at the end of the month. It buys call options with a strike price of Rs 82.80 at a premium of Rs 0.30.
| If USDINR | What the call does | What XYZ does |
|---|---|---|
| Falls sharply below 82.80 | The calls expire worthless, and the loss on the long call position is restricted to the premium already paid | Purchases dollars at a lower rate in the open market and benefits |
| Appreciates over the month | The profits on the long call position offset the extra cost | Buys dollars at higher prices, but the losses are offset by the call |
The workbook draws the conclusion: the importer has locked in a maximum purchase price of Rs 83.10 (82.80 + 0.30) for the dollars he needs at month end; but if USDINR trades below the strike price of 82.80, the importer can let his call options expire worthless and buy dollars at the market rate, which is lower than his strike price. The workbook labels the payoff chart Protective Call.
The ceiling formula. For a bought call used to hedge a payable:
| Working | |
|---|---|
| Maximum effective purchase rate | Strike + Premium |
| Maximum loss on the option itself | The premium |
| Benefit if the currency falls | Unlimited, down to zero, less the premium |
Note that this is the mirror image of the protective put, where an exporter's floor is strike minus premium. Same structure, opposite direction, because the cash flow runs the other way.
Where it fits the three hedging decisions (section 5.2). The contract follows the currency pair; the type of hedge follows the cash flow — a participant who has to make payment in USD is exposed to the risk of appreciation of USD against INR, and hence will either buy USDINR futures or buy a USDINR call option; and the contract month is chosen so the payment date is close to but before the expiry.
Cheapening it — Case 2. An edible oil importer believes there is a high probability of USD strengthening from 83 to 84 in three months, but thinks the dollar may weaken against other currencies so USDINR may not appreciate beyond 84. Wanting a cheaper alternative to a plain vanilla call, it can buy an ATM or ITM call option on USDINR and reduce its cost by selling an OTM call option. That is a bull call spread; the same payoff can be built with puts as a bull put spread. The actual strikes depend on premiums and management objective.
Sizing it — Case 3. A student going abroad for higher studies has a loan of Rs 15,00,000 sanctioned, must pay the university after one month, and wants an exchange traded call at a strike of Rs 83.00. The workbook's arithmetic: Rs 15,00,000 / 83 = USD 18,072; one lot is USD 1,000; so he buys 18 lots.
Contract mechanics that apply. Indian exchange traded currency options are premium style European call and put options, cash settled in Indian Rupees against the FBIL reference rate on the last trading day, with a strike interval of Rs 0.25 and a tick of Rs 0.0025. Only the writer posts mark-to-market margin; the importer has paid everything he can lose.
A worked example
XYZ Ltd, in full. The workbook's figures: USD 100,000 payable at month end, calls bought at a strike of 82.80 for a premium of Rs 0.30.
| Item | Working |
|---|---|
| Lots | 100,000 / 1,000 = 100 |
| Premium paid | 100 x 1,000 x 0.30 = Rs 30,000 |
| Ceiling rate | 82.80 + 0.30 = Rs 83.10 |
| Worst-case rupee cost | 100,000 x 83.10 = Rs 83,10,000 |
| USDINR at month end | Call payoff per USD | Market cost of USD | Effective rate | Rupees on USD 100,000 |
|---|---|---|---|---|
| 84.50 | 1.70 | 84.50 | 84.50 - 1.70 + 0.30 = 83.10 | Rs 83,10,000 |
| 83.50 | 0.70 | 83.50 | 83.50 - 0.70 + 0.30 = 83.10 | Rs 83,10,000 |
| 82.80 | 0 | 82.80 | 82.80 + 0.30 = 83.10 | Rs 83,10,000 |
| 82.30 | 0 | 82.30 | 82.30 + 0.30 = 82.60 | Rs 82,60,000 |
| 82.00 | 0 | 82.00 | 82.00 + 0.30 = 82.30 | Rs 82,30,000 |
Read the shape. Above the strike the effective rate is flat at 83.10 — that is the cap. Below it the rate falls one for one with the market. The importer paid Rs 30,000 to convert an unlimited upside risk into a fixed ceiling, without giving up the downside benefit.
Against the futures alternative. Had XYZ bought 100 USDINR futures at 82.90 instead:
| USDINR at month end | Protective call | Long futures |
|---|---|---|
| 84.50 | 83.10 | 82.90 |
| 83.50 | 83.10 | 82.90 |
| 82.30 | 82.60 | 82.90 |
| 82.00 | 82.30 | 82.90 |
The futures hedge is better when the dollar rises, because there is no premium to pay. The call is better when the dollar falls. The Rs 0.30 premium is the price of those last two rows, and on USD 100,000 that price is Rs 30,000.
The student, sized. Loan of Rs 15,00,000, strike Rs 83.00.
| Step | Working | Result |
|---|---|---|
| Dollars needed | 15,00,000 / 83 | USD 18,072 |
| Lot size | USD 1,000 | |
| Lots to buy | 18,072 / 1,000 | 18 |
He is left with USD 72 uncovered, because the lot size does not divide his exposure exactly — a partial hedge by arithmetic rather than by choice.
Why NISM asks about it
Chapter 5, section 5.3.7.2 (Buying Protection with call), is the source: the XYZ Ltd case with the 82.80 strike, Rs 0.30 premium and Rs 83.10 ceiling, the chart labelled Protective Call, the edible oil importer's bull call spread, and the student's 18 lots on a Rs 15,00,000 loan. Section 5.2 supplies the rule that a payer buys futures or buys a call. Expect a question asking for the maximum rate the importer can end up paying — the answer is strike plus premium — and one asking which hedge lets an importer benefit from a falling dollar.
Common exam traps
- The ceiling is strike PLUS premium for a payer. The protective put's floor is strike minus premium for a receiver. Mixing the two costs a mark.
- An importer buys a call, not a put. Direction follows the cash flow: a payer fears a rise and buys the right to buy.
- Buying a call is not a bullish speculation here. XYZ is hedging a payable; the workbook describes it as effectively taking a bullish view on USDINR, but the position exists because of the exposure, not the view.
- The premium is paid whatever happens. The Rs 30,000 is gone even in the best scenario, which is why the effective rate below the strike is market rate plus 0.30.
- A futures hedge beats the call when the currency rises, because it costs no premium. The call is not strictly better — it is better only on the downside.
- The student's answer is 18 lots, not 18.072. Lots are whole numbers, and the residue stays uncovered.
- Selling an OTM call to cheapen the hedge caps the protection above that strike. A bull call spread is not the same as a plain long call.
- Only the option writer posts mark-to-market margin. The importer's obligation ended when he paid the premium.
Where this is taught
Free preparation for NISM Series IRelated terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Contingent cash flowA foreign currency receipt or payment that may not happen at all — an unconfirmed order or an unsuccessful bid — for which the workbook prefers bought options to futures, because the loss is capped at the premium.
- Currency optionAn option giving the buyer the right, but not the obligation, to buy or sell an agreed amount of one currency against another at a specified exchange rate, on or before a specified future date.
- Effective priceThe rate a hedger actually ends up with: the price realised or paid in the spot market, adjusted by the payoff on the hedge — added for a receiver, subtracted for a payer.
- Call optionA contract giving its buyer the right, but never the obligation, to buy the underlying at a fixed strike price — so the loss is capped at the premium and the gain is not.
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
- Protective putBuying a put option to protect a foreign currency receivable: it sets a floor rate (strike minus premium) while keeping the benefit if the currency rises. Suited to contingent cash flows.
- Vertical spreadTwo options of the same type and the same expiry but different strikes, one bought and one sold — a limited-profit, limited-loss position that trades away part of the upside to cut the cost or cap the risk.
- Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.