FX or Currency Option is a financial derivative instrument under which the owner of the instrument gets the right but not the obligation to exchange one currency against another at a particular point of time in future at a predetermined exchange rate.
This predetermined rate is called as strike price or exercise price.
The market for FX Options is the largest & most liquid option market in the world. Most of the trading in FX Option happens in OTC (Over the Counter) markets & less regulated. A portion of the FX Option trading also happens on regulated exchanges like Philadelphia Stock Exchange, Chicago Mercantile Exchange and International Securities Exchange.
Example of FX Option:
Suppose in a EURUSD FX Option the terms of contract may specify that the owner of the instrument will have a right but not the obligation to sell EUR 1,000,000 on a particular date & buy 1,334,000 USD. The exchange rate implied in this contract is 1.334. This rate is the predetermined or strike price for per unit of EUR against USD. This rate can be arrived at by simply dividing the Notional values of the currencies involved. A close look of the above contract would reveal that this is both Call & Put option in the same contract. This is a Call Option for USD & Put Option for EUR. The owner has Option to buy or call USD & sell or put EUR on specified date.
Now suppose the actual exchange rate on specified date for EUR/USD is 1.255 the owner can exercise the Option to sell EUR 1,000,000 at 1.338 under the option contract & buy it back in Spot market at 1.255. This would result in a profit to the owner. (1.334-1.255) x 1,000,000 = 79000 USD in profit.
Let me explain this a little more.
Selling EUR 1,000,000 @1.334 would get 1,334,000 USD.
Now selling this 1,334,000 USD @1.255 would get 1,062,948 EUR
The net excess in EUR would be 62948. When we convert this to USD @1.255 it would come to 79000 USD in Profit.
FX Options in Hedging:
FX Options can be used as a Hedging tool to mitigate the risk involved in exchange rate fluctuations.
Example of Hedging Transaction with FX Option:
Suppose an exporter based in Europe is expecting to receive an order for a value of 1,000,000 USD & if the order is received the sell proceeds are expected from a buyer in US after say 1 Month. The exporter would need to convert the USD into EUR upon receipt of the funds. If the current exchange rate between EUR/USD is 1.334 (from above example) & in that case he is expecting 7,49,625 EUR after 1 month. Now suppose at the end of 1 month the actual exchange rate between EUR/USD increases to 1.500. What will be the effect on his cash flows in EUR? Let us see it below.
Expected Cash Flow in EUR = 749,625 (1,000,000/1.334)
Actual Cash Flow in EUR = 666,666 (1,000,000/1.500)
As can be seen above the exporter would receive less EUR due to appreciation in EUR against USD.
To avoid this loss the exporter can buy an FX Option to Sell USD 1,000,000& Buy EUR after one month with a pre decided rate or strike price of 1.334. This contract would enable the exporter to sell USD at 1.334 after one month ever though the actual exchange rate prevailing at that point of time would be 1.500.
This is a Hedge transaction to plan & mitigate the risk involved in exchange rate fluctuations.
Using options in currency trading is becoming popular over the recent past as a great way to make money with currency trading as well as to hedge the risk, and it has become a favorite technique of thousands of currency traders across the world.
Hedging Strategy with FX Options:
As a rule one should keep in mind that if the Cash flows are certain one should use FX Forwards & if the Cash flows are uncertain one should go for FX Option. Now you may ask why this is so? Let me explain this.
In case of a FX Option the buyer has an Option to buy or sell the currencies involved & no obligation to do so. But in case of forwards one has to buy or sell the stated currencies at the expiry of the stipulated period of time.
If the expected cash flow is not received at the time of expiry of the contract in case of a Currency Option, the buyer of contract may decide not to exercise his right to buy or sell the currencies & the only loss would be the Option premium which he has paid to buy the Option. But if the cash flow is not received in case of a FX Forward, the buyer is obliged to buy or sell the currency at the expiry of the forward contract. In this case the possible losses can be unlimited.
In the above case of an exporter we have seen that the exporter is expecting an order but the order is not yet confirmed & the Cash flow is not certain. Hence the exporter would go for FX Option & not the Forward. Now I hope this has clarified your doubt.
In summary we can say that FX Option is a very popular instrument for speculating as well as Hedging. I have a word of caution here for you. You should not assume that the currency options would always earn you money. There may be huge losses & it may hamper your finances badly. With highly volatile FX markets you should not speculate in Currency Options without a proper understanding of the FX market & detailed study is required on the subject.
This predetermined rate is called as strike price or exercise price.
The market for FX Options is the largest & most liquid option market in the world. Most of the trading in FX Option happens in OTC (Over the Counter) markets & less regulated. A portion of the FX Option trading also happens on regulated exchanges like Philadelphia Stock Exchange, Chicago Mercantile Exchange and International Securities Exchange.
Example of FX Option:
Suppose in a EURUSD FX Option the terms of contract may specify that the owner of the instrument will have a right but not the obligation to sell EUR 1,000,000 on a particular date & buy 1,334,000 USD. The exchange rate implied in this contract is 1.334. This rate is the predetermined or strike price for per unit of EUR against USD. This rate can be arrived at by simply dividing the Notional values of the currencies involved. A close look of the above contract would reveal that this is both Call & Put option in the same contract. This is a Call Option for USD & Put Option for EUR. The owner has Option to buy or call USD & sell or put EUR on specified date.
Now suppose the actual exchange rate on specified date for EUR/USD is 1.255 the owner can exercise the Option to sell EUR 1,000,000 at 1.338 under the option contract & buy it back in Spot market at 1.255. This would result in a profit to the owner. (1.334-1.255) x 1,000,000 = 79000 USD in profit.
Let me explain this a little more.
Selling EUR 1,000,000 @1.334 would get 1,334,000 USD.
Now selling this 1,334,000 USD @1.255 would get 1,062,948 EUR
The net excess in EUR would be 62948. When we convert this to USD @1.255 it would come to 79000 USD in Profit.
FX Options in Hedging:
FX Options can be used as a Hedging tool to mitigate the risk involved in exchange rate fluctuations.
Example of Hedging Transaction with FX Option:
Suppose an exporter based in Europe is expecting to receive an order for a value of 1,000,000 USD & if the order is received the sell proceeds are expected from a buyer in US after say 1 Month. The exporter would need to convert the USD into EUR upon receipt of the funds. If the current exchange rate between EUR/USD is 1.334 (from above example) & in that case he is expecting 7,49,625 EUR after 1 month. Now suppose at the end of 1 month the actual exchange rate between EUR/USD increases to 1.500. What will be the effect on his cash flows in EUR? Let us see it below.
Expected Cash Flow in EUR = 749,625 (1,000,000/1.334)
Actual Cash Flow in EUR = 666,666 (1,000,000/1.500)
As can be seen above the exporter would receive less EUR due to appreciation in EUR against USD.
To avoid this loss the exporter can buy an FX Option to Sell USD 1,000,000& Buy EUR after one month with a pre decided rate or strike price of 1.334. This contract would enable the exporter to sell USD at 1.334 after one month ever though the actual exchange rate prevailing at that point of time would be 1.500.
This is a Hedge transaction to plan & mitigate the risk involved in exchange rate fluctuations.
Using options in currency trading is becoming popular over the recent past as a great way to make money with currency trading as well as to hedge the risk, and it has become a favorite technique of thousands of currency traders across the world.
Hedging Strategy with FX Options:
As a rule one should keep in mind that if the Cash flows are certain one should use FX Forwards & if the Cash flows are uncertain one should go for FX Option. Now you may ask why this is so? Let me explain this.
In case of a FX Option the buyer has an Option to buy or sell the currencies involved & no obligation to do so. But in case of forwards one has to buy or sell the stated currencies at the expiry of the stipulated period of time.
If the expected cash flow is not received at the time of expiry of the contract in case of a Currency Option, the buyer of contract may decide not to exercise his right to buy or sell the currencies & the only loss would be the Option premium which he has paid to buy the Option. But if the cash flow is not received in case of a FX Forward, the buyer is obliged to buy or sell the currency at the expiry of the forward contract. In this case the possible losses can be unlimited.
In the above case of an exporter we have seen that the exporter is expecting an order but the order is not yet confirmed & the Cash flow is not certain. Hence the exporter would go for FX Option & not the Forward. Now I hope this has clarified your doubt.
In summary we can say that FX Option is a very popular instrument for speculating as well as Hedging. I have a word of caution here for you. You should not assume that the currency options would always earn you money. There may be huge losses & it may hamper your finances badly. With highly volatile FX markets you should not speculate in Currency Options without a proper understanding of the FX market & detailed study is required on the subject.
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