Protective put
Also written Long put hedge
Buying 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.
In plain language
An exporter expecting dollars fears the rupee will strengthen — USDINR will fall — before the money arrives. Selling USDINR futures fixes the rate, but also gives away any gain if USDINR rises.
A protective put keeps both. The exporter buys a USDINR put option:
- If USDINR falls below the strike, the put pays out and makes up the shortfall on conversion.
- If USDINR rises, the put expires worthless, and the exporter simply converts at the better market rate.
The cost is the premium, paid upfront. The workbook sums it up: the long put hedge allows one to lock-in a floor return while still retaining a great deal of the upside potential.
The floor is strike − premium, and the maximum loss on the option is the premium itself. That limited, known cost is exactly why options suit exposures that might not happen.
How it works
Contingent cash flows (Chapter 5, section 5.3.7.1). The workbook argues put options are more suited as a hedging tool for contingent cash flow receivables and gives two cases:
| Case | Why a put beats a futures hedge |
|---|---|
| Mango pulp exporter whose orders sometimes cannot be fulfilled | With short futures, an unfulfilled order plus a USD rally caused huge losses. With a put, the loss is limited to the premium. |
| Bidding for an overseas project | If the bid fails, a futures hedge leaves a speculative position with unlimited downside; a put can simply lapse (or be exercised at a profit if the currency fell). |
Cheaper variant. If the exporter expects only a modest rupee appreciation, it can buy an ATM or ITM put and sell an OTM put to reduce cost — a bear put spread (Case 4).
Unwinding early. Because exchange-traded currency options are cash settled, an exporter who receives dollars early can sell the put back and convert the dollars with the bank. The net rate is the bank rate plus (or minus) the gain (or loss) on the put.
The mirror image for an importer with a USD payable is buying a call — "buying protection with call".
The formula
Floor rate per USD = Strike − Premium
Net rate at expiry = max(Spot, Strike) − Premium
Maximum cost = Premium × Amount hedged
A worked example
1. The workbook's floor. An exporter expecting USD 1 million in a month buys USDINR puts, strike 83, premium Rs 0.20. One contract is USD 1,000, so 1,000 contracts.
Premium paid = 0.20 × 1,000,000 = Rs 2,00,000
Floor rate = 83.00 − 0.20 = 82.80
Two illustrative expiry rates:
| USDINR at expiry | Put payoff | Conversion | Net received | Per USD |
|---|---|---|---|---|
| 82.00 | (83 − 82) × 10,00,000 = Rs 10,00,000 | Rs 8,20,00,000 | 8,20,00,000 + 10,00,000 − 2,00,000 = Rs 8,28,00,000 | 82.80 |
| 84.00 | Nil | Rs 8,40,00,000 | 8,40,00,000 − 2,00,000 = Rs 8,38,00,000 | 83.80 |
Below 83 the rate never drops under 82.80; above 83 the exporter keeps the upside, less Rs 0.20.
2. Unwinding early (the workbook's Case 5). Put on USD 20,000, strike 83, bought at the offer of 0.37. Dollars arrive early; the put is sold at the bid of 0.48; the bank buys the dollars at 82.45.
Gain on put = 0.48 − 0.37 = Rs 0.11 per USD → Rs 2,200 on USD 20,000
Net rate = 82.45 + 0.11 = Rs 82.56 per USD
3. Unwinding at a loss (Chapter 4). Put on USD 20,000 bought at 0.075, cancelled at 0.04:
Premium paid = 20,000 × 0.075 = Rs 1,500
Premium received = 20,000 × 0.04 = Rs 800
Net loss = Rs 700
Why NISM asks about it
Chapter 5, section 5.3.7.1 (Buying protection with put options), presents the protective put with the Rs 83 strike and 82.80 floor, the contingent cash flow cases, the bear put spread alternative and the early unwinding example. Chapter 4, section 4.8, has the cancellation example. Expect "what is the minimum rate locked in" and "why options suit contingent exposures" questions.
Common exam traps
- Floor = strike − premium, not the strike alone.
- An exporter (USD receivable) buys puts; an importer (USD payable) buys calls.
- The premium is lost even if the put is never used — that is the price of keeping the upside.
- Options suit contingent cash flows; futures and forwards suit certain ones. A failed bid hedged with futures becomes a speculative position.
- When unwinding, the exporter sells at the bid and bought at the offer — use the right side of each quote.
- A bear put spread lowers the cost but caps the protection.
Where this is taught
- Series IV · Chapter 5: Strategies using Interest Rate Derivativesintroduced here
- Series I · Chapter 5: Strategies using Exchange Traded Currency Derivativesintroduced here
- Series XXI-B · Chapter 18: Equity Portfolio Management Strategiesintroduced here
- Series VIII · Chapter 5: Strategies using Equity Futures and Equity Optionsintroduced here
- Series V-D · Chapter 22: Strategies using Interest Rate Derivativesintroduced here
Related 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.
- 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 callBuying 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.
- 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.
- Put optionA contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
- Naked putIn this workbook, a put option taken for trading or speculation with no portfolio behind it — the counterpart of a protective put, which insures holdings the investor already owns.
- Butterfly spreadA four-legged position — one option bought at a low strike, two sold at a middle strike and one bought at a high strike, all of the same expiry — that caps the unlimited loss of a short straddle.
- Covered callHolding the underlying in the cash market and writing a call against it — a way of earning premium income from a holding, at the cost of capping the gain above the strike.
- Put-call parityThe arbitrage-free relationship binding a European call and put of the same strike and expiry to the spot and the discounted strike: c + X·e^(−rt) = p + S. Deviations create risk-free profit.
- InsuranceThe risk-management approach that pays an explicit upfront premium to remove the downside while keeping the upside — which in derivatives means buying an option rather than selling a future.
- 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.
- Partial hedgeCovering only a fraction of an exposure with derivatives, leaving the rest open — so the effective rate is a weighted average of the hedged rate and the spot rate.
- Synthetic long callA protective put position — long the stock plus a long put at the same strike — whose payoff, limited loss with unlimited upside, mimics that of an outright long call option.