What are the Currency Options?
Currency Options are Derivative contracts that enable market participants which includes 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.
Types of Currency Options
#1 – Currency Call
Such options are entered into with the intent to benefit 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.
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Simple Example of Currency Options
- 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 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.
- 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 –
- It allows traders to take leverage trades as the premium cost of the option contract 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.
- Due to the high leveraged position, Currency Options are prone to manipulation by speculators and cartels. Also, currency markets are controlled by the local government of each country, which impacts the Value of Currency Options.
This option 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.
This has been a guide to What are Currency Options and its Definition. Here we discuss the types along with the practical example, advantages, and disadvantages. You can learn more about excel modeling from the following articles –