Currency Options

Currency Options are Derivative contracts that enable market participants which include both Buyers and sellers of these Options to buy and sell the currency pair at a pre-specified price (also known as Strike Price) on or before the date of expiry of such derivative contracts.

These are Non-Linear instruments and are used by Market participants for both Hedging and Speculation purposes. The buyer of the Currency Option has the right but not the obligation to exercise the option, and to get the right; the buyer pays a premium to the Seller/Option writer.

• Currency options are derivative contracts that grant the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of one currency for another currency at a predetermined exchange rate (strike price) within a specified period. 
• Currency options are widely utilized by individuals, corporations, and financial institutions to mitigate foreign exchange risk, speculate on currency fluctuations, and hedge international transactions. 
• They offer opportunities to profit from favorable currency movements and protect against adverse changes.

Currency options trading are a kind of financial derivative contract which gives the holder of the contract the right and not the obligation to buy, which is called a call option or to sell, which is called a put option a certain amount of a particular currency by exchanging it with another currency at an exchange rate that is determined in advance at or before it expires. The rate of exchange is called a strike price.

It is commonly used by institutional investors , individuals or entities to hedge against exchange rate risk and protect themselves against any adverse exchange rate movements.

Currency options trading comprises of two values that together determine the cost of the option, namely; Intrinsic Value and Extrinsic Value

• Intrinsic value refers to the value by which the option is in the money. For example, Raven bought a USD/INR call with a strike price 72. The current price of the USD/INR is 73. In this case, the intrinsic value of this option is Rs 1, which is the amount by which the option is in the money.
• Extrinsic value is the value attributed to time and volatility associated with the currency pair. The more the time to expiry and the higher the volatility, the greater will be the extrinsic value of an option.

This is an effective way to make the most out of Currency pairs and are used effectively by Traders, Speculators, and Corporate, etc.

Here are the main features and components of the system.

• Call Option – The call option on any currency gives the holder of the contract a right to purchase the base currency at a particular exchange rate. The holder exercises the option when they believe that the base currency value will go up in comparison to the counter currency.
• Put option – This option gives the holder the right to sell the base currency and buy the counter currency at a previously fixed rate. This is done when the holder expects the value of base currency to fall.
• Strike price – The strike price is the rate at which the option holder exchanges the currencies. It is previously fixed when the option contract is made and does not change till the expiration date.
• Expiration date – It is the date beyond which the option contract will become invalid. Thus it is the time period within which the contract should be used.
• Premium – This is the price which the buyer pays to the seller so that they get the right to purchase or sell the currency. It depends on certain factors like the market volatility, expiration period, exchange rate, interest rate, etc.

There are various types of currency options, that are elaborated below:

#1 - Currency Call

Such options are entered into with the intent to benefit and get currency options hedge from the increase in the price of the currency pair. It enables the buyer of the option to exercise his right to buy the currency pair at the pre-specified strike price on or before the expiry date of the contract. If on expiry, the currency pair is below the Strike Price, the option ends worthless, and the Option seller pockets the premium received.

#2 - Currency Put

Such options are entered into with the intent to benefit from the decrease in the price of the currency pair. It enables the buyer of the option to exercise his right to sell the currency pair at the pre-specified strike price on or before the expiry date of the contract. If on expiry, the currency pair is above the Strike Price, the option ends worthless, and the Option seller pockets the premium received.

Some common strategies that are used for currency options trading are as follows:

• Hedging – This currency options hedge helps to protect against potential loss as a result of adverse movements of currency. If an organization has exposure to foreign currency and wants to protect itself from currency depreciation, it can go for put option to mitigate the risk of losses.
• Speculation – it is used to capitalize on currency movements that are anticipated in advance. The traders can go for call or put option as per their anticipated movements. Within a particular time period.
• Risk reversal – This is a combination of buying call option aand selling put option on the same currency and is commonly used by traders who want to offset the cost of their positions.
• Straddle – It involves simultaneously buying a call and also a put on the same expiration date and strike price. Traders use it when they expect that the currency market will be very volatile and is not sure of the direction that they should take.
• Covered call – A covered call strategy means holding a long position and and at the same time selling call option on that currency. In this case the premium received from selling the call is an income and provides a downside protection against the fall in currency value.
• Protective put – This is used by traders who want protection against currency fall. They purchase put option to establish a floor price for selling it. In case the currency falls, the put option gives the right to sell it at a predetermined strike price.

Let us try to understand the concept of currency options market with the help of some suitable examples.

Example #1

• Larsen International is undertaking a project in the United States of America and will receive revenue in Foreign Currency, which in this case, will be in US Dollars. The company wishes to protect itself against any adverse movement in the currency rate.
• To protect itself from any adverse moment which can arise on account of appreciation of local currency INR against the US Dollar, the company decided to purchase Currency Options. Larsen expects to receive the payment in the next three months, and the current USD/INR spot rate is 73, which means one dollar is equivalent to 73 rupees.
• By entering into an option with strike price 73 and expiry of three months, Larsen has covered its risk of fall in the price of foreign currency against the local currency Indian Rupee.
• Now, if the overseas currency US Dollar strengthens in the interim period, the company will benefit from stronger currency when translating its profits in Indian Rupee and will suffer the loss of the premium paid to purchase the option.
• However, on the contrary, if the foreign currency got weaker compared to the local currency INR (which means INR getting stronger against US Dollar), the currency option purchased by Larsen will ensure that it can translate its profit in India Rupee at the pre-specified rate, i.e., Strike Price.
• Avon Inc specializes in Hedge trades of such options. The firm believes that the current USD/INR spot rate of 73 can reach a maximum of up to Rs 74 against the dollar in the next three month and decided to profit from such a move and entered into a Strangle trade by buying and selling the call option and put option with strike price 74.

Example#2

Position:

• Sold a three month USD put INR call option on $ 1 million with a strike price of 74.00
• Bought a three month USD call INR put option on $ 2 million with a strike price of 74.00

To derive the value of the Currency Call and Put Option, the firm calculates the price of the two options based on the Black Scholes Pricing Model. Derivation of rates is mentioned below -

As one can observe, the graph below shows profits or losses on the basis of the spot rate or time of exercising the option or expiry.

The example denotes that a buyer, for example, Sam, wishes to offload Australian dollars and purchase US dollars. However, Sam expects that the value of AUD will depreciate in comparison to the US dollar in the future. He buys a call on USD to hedge against AUD’s depreciation.

Sam sets the strike price at $2.4. This gives him the right to offload AUD at 2.4 USD/AUD prior to expiration. In case the AUD depreciates over USD/AUD, towards the right, Sam will choose to exercise the option as it will be in the money or ITM.

At the strike price, Sam will be indifferent between not exercising and exercising, ignoring potential exercising fees. That said, in case AUD appreciates against USD towards the strike’s left, this option would not be worth anything because it will be out of the money or OTM, and the purchaser would incur losses on the options contract.

Individuals can compute the overall premium by multiplying the total size of the contract by the premium. So, considering a contract size of 100,000 USD and a 0.2 AUD premium, the overall premium paid will be $20,000.

Note that the calculation of the break-even spot rate, in this case, will involve adding the premium and strike price. The graph shows that the break-even will be $(2.4 + 0.2), i.e., 2.6 USD/AUD. One can consider the break-even rate the spot rate required to earn the overall premium paid back.

At the break-even point, Sam would exercise the call option and offload the AUD at 2.4 USD/AUD when the strike price is 2.6. The gain will equal ($2.6-2.4) x 100,000 or 20,000 AUD.

The gain will be an identical amount to offset the overall premium incurred by Sam for the options contract. Note that a spot rate between the break-even and the strike price incurs an overall loss because the gains cannot cover the overall premium. As a result, if Sam has to earn any money out of the contract, he must anticipate AUD to depreciate past the $2.6 USD/AUD break-even .

Some of the advantages of the concept are as follows:

• It allows traders to take leverage trades as the premium cost of the currency options contracts is very minimal compared to the actual buying of the contract, which enables them to take a large position by paying a nominal premium.
• It is a low-cost tool for hedging and can be used by Corporate to hedge against any adverse currency movement.

Along with the advantages, it is necessary to identify the disadvantages of the concept, which are as given below:

• Due to the high leveraged position, currency options contracts are prone to manipulation by speculators and cartels.
• The currency markets are controlled by the local government of each country, which impacts the Value of Currency Options.

Here are some basic differences between the two types of financial terms.

• The former gives the right but ot the obligation to the holder to purchase and sell the underlying currency, whereas the latter creates only an obligation for both the buyer and seller regarding the transaction related to the currency.
• The former is customised and flexible in terms of price, expiration date or size of the contract, but the latter is standardised and is traded in regulated exchanges.
• For the currency options market buyer, the loss is limited to the premium and the option seller’s risk is unlimited, but in case of currency futures, the loss is unlimited for both seller and the buyer.
• For the former, the buyer pays premium to the seller whereas for the latter, a margin money is need which is a part of the contract value.

This has been a guide to Currency Options and its definition. We explain it with examples, trading strategies, types, features, advantages & disadvantages. You can learn more about excel modeling from the following articles –

• Option Chain
• Option Contract
• Bermuda Options
• Exotic Option