Updated July 14, 2023
Definition of Currency Options
Currency Options are a contract that gives the buyer the right to buy or sell a certain currency at a specified exchange rate on or before the specified date, which is not obligatory and is the most common way of reducing the risk of exchange rate fluctuations.
Explanation
A currency option reduces the risk by entering into a contract for buying or selling the currency at a specified price on or before the specified date. It is the most effective way to reduce the exchange rate fluctuations risk. For example, A trader who purchased goods from a foreign country has to make payment in that country’s currency within the period specified in the contract. For that, the trader might enter into a currency option contract to reduce the risk of increased payment in the future. A currency option is also a way of earning profit through hedging the risk and through speculations. However, Losses can occur in currency option contracts if the domestic currency appreciates or the foreign currency depreciates. The currency market fluctuation depends upon the market conditions, which depend upon several factors.
Features of Currency Options
Features of Currency Options are as under:
- Premium: The holder of options has to pay a certain amount called a down payment or premium for having a right to exercise an options trade. The premium is non-refundable. Therefore, the holder may lose the premium if he does not exercise the currency option.
- Validity Period: Every Currency option has a limited validity period, which means it comes with an expiration date, and the holder has to exercise the option on or before the validity period.
- Specific Price: The currency option has to be exercised at a specific price called a Strike price. It is the price at which the owner of the option can buy or sell the underlying security under the contract of the option till the validity of the currency option.
- Settlement of The Option: When exercising the contract, the settlement of the option needs to be done. There is no buying or selling of a security in the option contract entered into.
How to Trade in Currency Options?
The currency options are traded through the stock exchanges of the respective countries. Some exchanges deal with many currency options that might be in multiple of 100. In addition, there are Call Options for the purchase of currency and the put option for the sale of the currency.
Currency options are also traded through the broker. Therefore, if the trader wants to enter into a currency option for the purchase or sale of foreign currencies, it has to approach the broker, who will charge the brokerage for entering into the contract on behalf of the trader.
Example of Currency Options
Mr. A, a Resident of India, purchased the imported machinery from the USA. The machinery cost was $ 50,000, and on the date of purchase, the exchange rate was 1$ = Rs. 60. Mr. A has to pay after 4 months. So he entered into the currency option contract today to purchase US dollars after 4 months at a predetermined price of 1 $ = Rs. 65. The premium paid was 1% of the transaction. The rate after 4 months was 1 $ = Rs. 62. Determine whether Mr. A should enter into a contract.
Solution:
Amount to be paid if exercised the option
- = $50000 * 65
- = $3,250,000
Cost of non exercising the option
- = $3,250,000 * 1%
- = $32,500
Total cost if the option is not exercised
- = $50000 * 62 + 32500
- = $3,132,500
Cost if Option is exercised = $3,250,000
Cost of Option is not exercised = $3,132,500
It is advisable not to exercise the option.
Types
A few Types of Currency Options are defined:
- Call Option: Under the Call option, the option owner gets the right to buy the security. The call option is not obligatory in nature. To buy the Call Option, the owner needs to pay the price called a premium.
- Put Option: Under Put Option, the owner can sell the securities at a specific strike price within the contract’s validity. A put option is also not obligatory; if the trader finds an advantage in profit, he can only exercise the option. For entering into the put option, the trader has to pay the price known as the premium or purchase the put option through the broker.
Advantages
The advantages of Currency Options are as under:
- Low Cost of Entry: To enter into the currency option, one must pay a nominal premium as the cost of entry is very nominal.
- Risk Coverage: Currency options are the best way to reduce foreign exchange fluctuations risk.
- Flexibility: Currency Options give the purchaser flexibility by allowing the option to exercise the option, which is not obligatory.
Disadvantages
The disadvantages of Currency Options are as under:
- Lower Liquidity: Due to low liquidity, it is not easy to buy or sell the options.
- Risk: Though the Contract of Currency Options is to cover the risk, if the options become unfavorable to the buyer and he does not exercise the option, he may lose the amount paid as a premium for entering into the option.
- Complicated in Nature: Currency Options are complicated, especially for beginners. Also, price fluctuations are per the market conditions, which may be favorable or unfavorable.
Conclusion
Currency Option is one of the ways to reduce the risks of exchange rate fluctuations. It is a contract for entering into an option at a specific price during the contract’s validity. There are two types of currency options; one is the call an option, also called an option for buying the currency, and the other is the put option, also called an option for selling the currency. The most important advantage of the currency options is risk coverage through hedging, the risk of exchange rate fluctuations is covered through the currency options, but the investor will lose the amount called a premium, which was paid when entering into the currency options.
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This is a guide to Currency Options. Here we also discuss the definition and how to trade in currency options. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –
