Currency Options
Currency Option is a financial instrument that provides its holder a right to buy
or sell a pre-specified amount of a foreign currency at a pre-determined rate in
the future. The future date will be on a fixed maturity date and/or will be valid
up to a certain period. Currency option entitles its holder a right only, but there
is no obligation on the part of the holder to buy or sell. Although, forward and
future contracts eliminates uncertainty and risk as regards risk fluctuations, these
contracts deprive the firm of an opportunity to reap the advantages that may accrue
due to favorable movements in the currency rates of foreign exchange. These disadvantages
of forward contracts have led to the emergence of currency options. The purchaser
of the option is risk averse with respect to exchange rate fluctuations. The seller
of the currency option assumes the risk in this case. There are two types of Currency
options, namely, call option and put option.
Call Option:
Call option is a type of currency option in which the holder has the right to purchase
or call a specific foreign currency at a price specified on a specific maturity
date or within a pre-specified period of time. As is the feature of any currency
option, the holder of the option is under no obligation to purchase the foreign
currency. He only has the right to exercise if he wishes. But a call option can
be exercised only when the actual currency rate in the foreign exchange market is
more than the rate specified in the contract of call option, at the time of exercising
the option. In cases where the actual currency rate in the spot market is lower
than the rate specified in the call option, at the time of exercising the option,
the holder obviously will not use the option.
Put Option:
Put option is a kind of currency option in which the holder has the right to sell
a specific amount of foreign currency. The selling of foreign currency should be
at a pre-fixed price on or up to a specified date. The holder of the put option
will exercise his put option right in cases when the actual foreign exchange price
on the maturity date is lower than the price specified in the contract of put option.
The currency option transactions have the following advantages:
- Currency option transactions, call and put options, hedge foreign exchange risk of fluctuating exchange movements rates.
- Currency option transactions retain the advantage of availing any favorable movement of exchange rates.
Some aspects of currency options:
- The cost of currency options is normally expressed as a percentage of the spot rate prevailing at the time of entering into contract. This cost may be limited to the amount of premium.
- Usually in call option contracts, the risk seems to be more to the seller than the buyer. These kinds of option contracts are mainly dealt in the major revolving currencies used around the globe and that which are traded in OTC market actively. OTC refers to over-the-counter market.
- The option is called an European option when it can be exercised only on the maturity date. The option is called an American option when it can be exercised on any date upto maturity.
- If the exercise of an option immediately yields a positive value to its holder, it is said to be in-money. The option is said to be at-money, in case where the strike price (exercise price) is equal to the spot price. An option is said to be out-of-money when it has no positive value.
- At the time of entering into an option contract, the price paid by the buyer is called as the option price or premium.
- Exercise price or strike price is the pre-determined price at which the purchaser of the option can exercise his option to purchase or sell the foreign currency.
- Currency options can be repurchased or sold before the maturity date. This facility is applicable in case of American options.
- The intrinsic value of European and American options is
given below:
American option intrinsic value = Spot rate – Exercise price
European option intrinsic value = Forward rate – Exercise price
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Topics under Foreign Exchange Market (FOREX):
