Currency Options

Currency Options

Meaning of a Currency OptionTypes of OptionsClassification of OptionsHedging and Speculation Using Currency OptionsDetermining profit/loss on an option

Currency OptionsA contract between two parties—a buyer and a seller/writer—in which the buyer purchases from the seller/writer the right to buy or sell a currency at a predetermined exchange rate. The buyer pays the seller a fee called the premium, which is the option’s price.

An option to buy an asset at a predetermined price (also known as exercise price) is known as the call optionAn option to sell as asset at a predetermined price (also known as exercise price) is known as put option

Types of Options

European StyleIt can be exercised at the discretion of the option buyer/option holder only at the maturity of the option

American StyleIt can be exercised at the discretion of the option buyer/option holder at any time before maturity or at maturity of the option

Classification of Options

In-the-Money OptionOne that would lead to positive cash flows to the holder if it were exercised immediately

At-the-Money OptionOne that would lead to zero cash flows to the holder if it were exercised immediately

Out-of-Money OptionOne that would lead to negative cash flows to the holder if it were exercised immediately

In-Money Calls and PutsCall is in the money if ST > E

Put is in the money if E > ST

Out of Money Calls and PutsCall is out of money if ST < E

Put is out of money if E < ST

Strategies Using Currency Options

Long a Call Option/Buy a Call Option

Buy a right to purchase a foreign currency at a predetermined exchange rate

Long a Put OptionBuy a right to sell a foreign currency at a predetermined exchange rate

Hedging and SpeculationForeign Currency Cash OutflowsRisk: Foreign currency may increase in value against domestic currencyStrategy: Buy a call option on the foreign currencyForeign Currency Cash InflowsRisk: Foreign currency may decrease in value against domestic currencyStrategy: Buy a put option on the foreign currency