Currency options

Currency options are a tool for hedging foreign exchange risk.

A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.

Different types of currency options

Basics

A call option gives the holder the right to buy the underlying currency.

A put option gives the holder the right to sell the underlying currency.

Options are more expensive than the forward contracts and futures.

A European option can only be exercised on the expiry date whilst an American option can be exercised at any time up to the expiry date.

Over the counter (OTC) options

Currency options can be bought OTC or on major exchanges.

Like forward contracts, the OTC options are tailor made to fit a company's precise requirements. Branches of foreign banks in major financial centres are generally willing to write options against their home currency.

• e.g. Australian banks in Chicago will write options on the Australian dollar.

Option sizes are much larger on the OTC market, with most options being in excess of $1 million.

Exchange traded options

Exchange traded options are also available but the OTC market is the larger.

• e.g. Euronext.liffe (formerly LIFFE) offers European style dollar:euro option contracts.

Two types of currency option are available:

• Cash options contracting for delivery of the underlying currency.
• Options on currency futures.

Illustration: Currency options

A typical pricing schedule for the US$/€ currency option on the Philadelphia exchange is as follows.

• Here, the options are for a contract size of €125,000 and prices (both strike price and premia) are quoted in US$ (cents) per €.
• So to buy a call option on €125,000 with an expiry date of September and at a strike price of €1 = $1.17 would cost 1.55 cents per euro, or $1,937.50.
• Similarly, the premium on a June put at a strike price of 115.00 (€1 = $1.15) would cost 0.64 cents per euro, or $800.

Options hedging calculations

Step 1: Set up the hedge by addressing 4 key questions:

• Do we need call or put options?
• How many contracts?
• Which expiry date should be chosen?
• Which strike price / exercise price should be used?The decision as to which exercise price to choose will depend on cost, risk exposure and expectations. If you have to choose in an exam then one approach is to  consider the cost implications only for calculation purposes: The best exercise price is then the one which (incorporating the premium cost) is most financially advantageous.

Step 2: Contact the exchange. Pay the upfront premium. Then wait until the transaction / settlement date.

Step 3: On the transaction date, compare the option price with the prevailing spot rate to determine whether the option should be exercised or allowed to lapse.

Step 4: Calculate the net cash flows - beware that if the number of contracts needed rounding, there will be some exchange at the prevailing spot rate even if the option is exercised.

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