What are the Currency Options?

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 pairCurrency PairA currency pair is a combination of two different national currencies valued against one another. Its purpose is to compare the value of one particular nation’s currency to another.read more. 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 PriceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more, 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

Practical Example

Position:

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

Advantages

  • 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 hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more and can be used by Corporate to hedge against any adverse currency movement.

Disadvantages

  • Due to the high leveraged position, Currency Options are prone to manipulation by speculators and cartelsCartelsA cartel is a group of producers of goods or suppliers of services formed through an agreement amongst themselves to regulate the supply of goods or services with the basic intent to illegally regulate the prices or restrict competition regarding the said goods or services.read more. Also, currency markets are controlled by the local government of each country, which impacts the Value of Currency Options.

Important Points

This option comprises of two values that together determine the cost of the option, namely; Intrinsic Value and Extrinsic ValueExtrinsic ValueThe extrinsic value of the option is one of the components of the total value of the option due to time value and the impact of volatility of the underlying asset. This part of the option value does not consider the intrinsic value that accounts for the difference between the spot price and exercise price of the underlying security.read more

  • 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.

Conclusion

This is an effective way to make the most out of Currency pairs and are used effectively by Traders, SpeculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more, 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 –

  • Option ChainOption ContractBermuda OptionsExotic Option