A foreign currency option gives its owner the right, but not the obligation, to buy or sell currency at a certain price (known as the strike price), either on or before a specific date. In exchange for this right, the buyer pays an up-front premium to the seller. The income earned by the seller is restricted to the premium payment received, while the buyer has a theoretically unlimited profit potential, depending upon the future direction of the relevant exchange rate. Foreign currency options are used to hedge against the possibility of losses caused by changes in exchange rates.
Foreign currency options are available for the purchase or sale of currencies within a certain future date range, with the following variations available for the option contract:
- American option. The option can be exercised on any date within the option period, so that delivery is two business days after the exercise date.
- European option. The option can only be exercised on the expiry date, which means that delivery will be two business days after the expiry date.
- Burmudan option. The option can only be exercised on certain predetermined dates.
The holder of a foreign currency option will exercise it when the strike price is more favorable than the current market rate, which is called being in-the-money. If the strike price is less favorable than the current market rate, this is called being out-of-the-money, in which case the option holder will not exercise the option. If the option holder is inattentive, it is possible that an in-the-money option will not be exercised prior to its expiry date. Notice of option exercise must be given to the counterparty by the notification date stated in the option contract.
A foreign currency option provides two key benefits:
- Loss prevention. An option can be exercised to hedge the risk of loss, while still leaving open the possibility of benefiting from a favorable change in exchange rates.
- Date variability. The treasury staff can exercise an option within a predetermined date range, which is useful when there is uncertainty about the exact timing of the underlying exposure.
There are a number of factors that enter into the price of a currency option, which can make it difficult to ascertain whether a quoted option price is reasonable. These factors are:
- The difference between the designated strike price and the current spot price. The buyer of an option can choose a strike price that suits his specific circumstances. A strike price that is well away from the current spot price will cost less, since the likelihood of exercising the option is low. However, setting such a strike price means that the buyer is willing to absorb the loss associated with a significant change in the exchange rate before seeking cover behind an option.
- The current interest rates for the two currencies during the option period.
- The duration of the option.
- Volatility of the market. This is the expected amount by which the currency is expected to fluctuate during the option period, with higher volatility making it more likely that an option will be exercised. Volatility is a guesstimate, since there is no quantifiable way to predict it.
- The willingness of counterparties to issue options.
Banks generally allow an option exercise period of no more than three months. Multiple partial currency deliveries within a currency option can be arranged.
Exchange traded options for standard quantities are available. This type of option eliminates the risk of counterparty failure, since the clearing house operating the exchange guarantees the performance of all options traded on the exchange.
Foreign currency options are particularly valuable during periods of high currency price volatility. Unfortunately from the perspective of the buyer, high volatility equates to higher option prices, since there is a higher probability that the counterparty will have to make a payment to the option buyer.