A currency option contract is a financial instrument used to reduce foreign exchange (FX or Forex) risk. It is a method of removing the risks associated with doing business in another country.
Currency options are contracts that give the buyer the right but not the obligation to buy or sell a chosen currency at a specified exchange rate on or before a specified date.
The exchange rate used on the day the currency option is exercised depends on what happens in the currency markets. If the rate has improved from the initial rate used for the option, the holder will benefit from the improvement. If the rate has become less favourable than the initial rate used, the holder benefits from being guaranteed the initial FX rate.
Buyers of currency option contracts pay a small premium or protection cost that guarantees the FX rate for the duration of the contract. The cost of the premium for a currency option contract involves the following factors:
ABC Ltd. is based in the UK and needs to pay an invoice for $15,000 (USD) in 3 months time. They elect to use a currency option contract to secure a guaranteed exchange rate for the transaction.
Today’s exchange rate is 1 GBP equals 1.3141 USD. Meaning $15,000 (USD) will cost them £11,415. Happy with the conversion, ABC Ltd. creates the option with a protection period of 3 months - the protection costing the company £302.05.
If in 3 month’s time the exchange has become more favourable, ABC Ltd will benefit from that change. If, however, the exchange rate has become less favourable, they are guaranteed the initial FX exchange rate.
Every business which has an exposure to foreign currency should have a foreign exchange policy to minimize any losses due to the fluctuations in the currency market. Expertise is needed to formulate this policy, and to follow it.
Businesses which operate in markets or territories outside their own currency are exposed to FX risk. Managing this risk is a key task for any finance or treasury department. While large multinationals have always had access to the full suite of hedging tools, SMEs and smaller corporations have often been underserved by their FX provider.
The financial crisis in 2008 underlined a growing trend of globalisation and economic instability within the FX space. In a high volatility environment, traditional hedging tools such as the FX Forward have left companies trapped with unfavourable exchange terms.
With the rise in volatility, the popularity of FX options has risen as a means of no-obligation hedging as an alternative to ‘traditional’ methods. With an FX Option you can purchase the right rather than the obligation to complete an exchange of currency at an agreed rate and exchange date in the future.
Apart from the stated benefit of an FX option, in times of high market volatility, FX options also offer other unique benefits which set them apart as an FX hedging tool.
Unlimited Upside - FX options allow the holder to benefit from unlimited upside should the rate go in their favour while still offering a defined downside or ‘worst case’ rate.
No Margins Required - FX options also help treasurers to avoid the high cost of carrying associated with high-interest rates in emerging markets when booking an FX Forward. In addition, FX options need no margin funding throughout the life of the contract.
Flexibility - The holder of a currency option contract may exercise the option at anytime during the life of the protection contract at no additional cost. This offers flexibility in payment and the ability to potentially recoup some of the initial cost should the exchange no longer be needed.
Budgeting - The future value of imports and exports are known in advance.
Protection - The holder of a currency option contract is protected against unfavourable rates while also being guaranteed benefits if the rate proves more favourable.
While FX options are an extremely robust hedging product the added functionality inherent in the contract means that an upfront payment must be paid to secure the option. As traditional hedging tools price, the sellers profit into the exchange rate directly, this upfront cost can be seen as expensive in comparison.
FX options also rely on a certain level of volatility to make them a profitable hedging strategy. Unless the market is sufficiently volatile, the cost of the option premium can be higher than the monetary benefit of the option upon expiry.