What it means
A currency option has a few simple parts. The strike price is the agreed exchange rate, the expiry date is when the right ends, and the premium is the price paid to buy the option.
A call option gives the right to buy the foreign currency at the strike rate, and a put option gives the right to sell it. If the market moves in the buyer's favour, the option is exercised or sold at a profit, and if it moves the wrong way, the buyer simply lets it expire.
That is the big difference from a forward contract, which commits both sides to the trade. With an option the most a buyer can lose is the premium, while the potential gain is open-ended, and that asymmetry is what the premium pays for.
Premiums depend on how far the strike is from the current rate, how long until expiry, how volatile the currency pair has been, and the gap between the two countries' interest rates. A longer option or one on a jumpier currency pair costs more.
Companies use options to cap the worst case on a future payment or receipt without giving up the chance of a better rate. A treasurer who is bidding for a contract in a foreign currency, and does not yet know if it will be won, often prefers an option since there is no obligation if the bid fails.
Sellers of options (writers) collect the premium but take on the risk of large losses if the market moves sharply against them. That is why selling options is mainly done by banks and experienced traders who can manage the risk.
In practice
Real-world examples.
Example
A US furniture importer must pay a Danish supplier 500,000 euros in three months. It buys a call option on euros so that its cost is capped, and it still benefits if the euro weakens before payment.
Example
A software company has bid for a contract worth 2,000,000 Australian dollars, with the result unknown for six weeks. It buys a put option on Australian dollars, which protects the value of the revenue if the bid wins and costs only the premium if it fails.
Example
A speculative trader expects a central bank announcement to move a currency pair sharply, but cannot tell the direction. The trader buys both a call and a put, accepting the combined premium in return for profiting from a large move either way.
Formula
Calculation
Breakeven rate (call) = strike rate + premium per unit
Profit at expiry = (spot rate at expiry - strike rate) x contract size - total premium paid
Suppose a US importer buys a call option on 100,000 euros with a strike of $1.1000 per euro, paying a premium of $0.0150 per euro. The total premium is 100,000 x 0.0150 = $1,500. The breakeven rate is 1.1000 + 0.0150 = $1.1150 per euro.
If the euro is at $1.1500 at expiry, the option is worth (1.1500 - 1.1000) x 100,000 = $5,000. The profit is 5,000 - 1,500 = $3,500. If the euro ends at $1.0800, the option expires worthless and the loss is limited to the $1,500 premium.Case study
Seen in the real world.
Lakeshore Outfitters is an illustrative, fictional US retailer that buys most of its stock from suppliers invoicing in euros. The finance director was worried about a falling dollar, but did not want to lock in a forward rate in case the dollar rose instead.
She bought a series of three-month call options on euros, covering about 60% of expected purchases. The total premium was budgeted as a hedging cost, much like an insurance premium, and the remainder of the exposure was left open.
In this illustrative case, the dollar did weaken, the options paid out and the company's margins held steady. The finance director noted that if the dollar had strengthened the options would have expired worthless, and the premium would have been the cost of certainty.
Watch out
Common mistakes.
- Ignoring the premium when judging a hedge, when the premium sets the breakeven point and is a real cost that must be budgeted.
- Treating an option as a forward contract, when an option gives a choice and a forward gives an obligation.
- Selling options to earn premium income without understanding that the potential loss can be many times the premium received.
Questions
People also ask.
What is the difference between a call and a put?
A call gives the right to buy the currency at the strike rate, and a put gives the right to sell it.
Why are options more expensive than forwards?
A forward costs nothing upfront because it carries an obligation, while an option gives you flexibility and the seller charges a premium for providing it.
When should a business choose an option?
When the future cash flow is uncertain, such as a bid that may not be won, or when it wants protection from bad moves while keeping the benefit of good ones.
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