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

11

Currency or FX Options

INTRODUCTION

A standard or ‘vanilla’ currency or FX option is:

• the right but not the obligation;

• to exchange two currencies at a fixed rate (the strike rate);

• on or by an agreed date in the future (the expiry date).

Contracts are either negotiated directly between two parties in the over-the-counter market, or traded through an organized derivatives exchange. European-style options can only be exercised at expiry, but American-style options can be exercised early if desired. In most cases exercise involves the actual exchange of two currencies, but some FX options are cash-settled. There is an example of a cash-settled contract at the end of this chapter.

Structure of an FX Option

An FX option is a little different to a stock option. This is because 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 EUR 10 million and to receive in return $15 million. In this case:

• the contract is a euro put (the right to sell euros);

• it is also at the same time a dollar call (the right to buy US dollars);

• the strike rate is EUR/USD 1.5000 i.e. if the option is exercised each euro buys $1.5.

USERS OF CURRENCY OPTIONS

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 ...