Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 11. Currency Options

INTRODUCTION

A European-style currency or FX option is the right but not the obligation to exchange two currencies at a fixed rate (the strike rate) on an agreed date in the future (the expiry date). American-style contracts can be exercised before expiry. Contracts are either negotiated directly between two parties in an over-the-counter transaction, or traded through an organized futures and options exchange.

The right to sell one currency is also the right to buy the other currency involved in the contract. Suppose that an FX option contract conveys the right but not the obligation to sell €10 million and to receive in return $11.5 million. The contract is a euro put (the right to sell euros) and at the same time a dollar call (the right to buy US dollars). The strike or exercise price is €/$ 1.15, i.e. each euro buys 1.15 US dollars. Currency options are widely used by corporations, institutional investors, hedge funds, traders, commercial and investment banks, central banks and other financial institutions. They can be used to:

• limit the risk of losses resulting from adverse movements in currency exchange rates;

• hedge against the foreign exchange risk that results from holding assets such as shares or bonds that are denominated in foreign currencies;

• enhance returns on foreign currency investments;

• speculate on the movements in currency rates with limited risk.

Because they offer flexibility, currency options can be attractive hedging tools. As we saw ...