There are two times in a man's life when he should not speculate: when he can't afford it and when he can.
— Mark Twain
Currency options are a useful tool for managing the multinational corporation's exposures to currency risks. Currency options are derivative securities, in that their value is derived from the value of an underlying exchange rate. As exchange rates change, so do the values of options written on the exchange rate. This chapter employs simple graphs to develop the intuition behind option valuation and their use in hedging currency risks. The technical details of option valuation are presented in the appendix to the chapter.
6.1 What Is an Option?
The difference between an option and a forward or futures contract comes down to choice. Currency options are like forwards in that they allow two parties to exchange currencies according to a prearranged date, amount, and exchange rate. In a forward contract, both sides have an obligation to perform. In an option contract, one side has the option of forcing the exchange while the other side has an obligation to perform if the option holder exercises the option. One side of the agreement has the option, and the other side of the agreement has the obligation. This is the fundamental difference between option and forward contracts.
There are two types of financial options—calls and puts.
- A currency ...