A currency option is a contract through which a seller offers a buyer the right, but not the obligation, to purchase or sell a specific currency at a defined exchange rate on or before a fixed date.
Currency options are financial derivatives. Its value is “derived” from the underlying asset. In this case, a specific currency pair.
Call options allow the holder to buy a currency pair at a stated price within a specific timeframe. Put options allow the holder to sell a currency pair at a stated price within a specific timeframe.
There are a few key components in a foreign currency option.
- The Premium is the price that the option buyer pays for the right to buy or sell that currency at a fixed rate on or before a specific expiration date.
- The Strike Price is the exchange rate at which the currency will be bought or sold before that maturity date.
A Japanese company with USD/JPY exposure could buy a currency option with an expiration date set for six months later to protect itself against any adverse currency movements if they have a USD payment due on that date.
If the strike price is more favorable than the spot exchange rate on the date on which this option matures, the option expires “in the money” (“ITM”) and the holder should exercise it.
However, if the exchange rate on the expiration date is better than the strike price, the holder will not exercise his option. In this scenario, the option expires “out of the money” (“OTM”).
While currency options are one of the hedging instruments available to businesses, in practice, they are mostly used for speculation.
Currency traders use options to make money by purchasing the option and simultaneously exchanging that cash on the spot market to pocket the difference.