Foreign currency options

Currency options have become an invaluable tool for reducing foreign exchange risk. What kinds of options are available and how do they work?

Currency options are similar to those used by share traders in order to make money on the future value of a company’s share price. They work by allowing the holder of the option the right to enter into a foreign exchange contract at some point during a pre-agreed period. The holder of the option can choose to enter into the contract, or to let it lapse, if the contract will not benefit them.

As in the sharemarket, there are basically two types of options:

• Put options, and
• Call options.

A put option gives the option buyer the right to sell a particular currency at the agreed strike price (or exercise price), prior to the expiration date. A. call option gives the option buyer the right to buy a particular currency at the strike price prior to the expiration date. The strike price is determined at the time the option is bought.

Options provide the buyer with the right to buy or sell the underlying currency prior to the expiration date. The buyer of the option is not obliged to buy or sell the option prior to the expiration date if it is not to their advantage. If the currency is ‘out-of –money’ in other words it is more advantageous to purchase the currency at the current market rate, then the option expires without being used and becomes worthless.

Foreign currency option deals in Australia usually involve Australian dollars as the underlying currency.

As importers are looking to sell Australian dollars, they would generally purchase put options. While exporters are looking to buy Australian dollars they would therefore purchase call options.

There are also many variations to these two types of options including knockouts and knock ins and basket options.

Options are different from Forward Exchange Contracts in that there is no obligation to exercise the right of the options, if the currency exchange rate puts the options ‘out of the money’. Forward Exchange Contracts on the other hand, oblige both parties to either buy or sell foreign currency at a fixed rate in the future.

There are two types of Forward Exchange Contracts:

1. Fixed term contracts
2. Optional term contracts.

Fixed term contracts involve the currency exchange taking place at a specified date in the future.

Optional term contracts are more flexible. A time period is nominated in which the exchange must take place. This timeframe is not usually more than a month. Therefore, the exchange can be for six months in the future with the deal having to take place within the last month.

Options offer the opportunity to insure against adverse fluctuations in foreign currency exchange rates and are increasingly being used by importers, exporters, farmers and others who are dealing with foreign currency throughout the year.