Definition of Currency Options
Currency Options is a type of contract that gives the buyer the right to buy or sell a certain currency at a specified exchange rate on or before the specified date, which is not obligatory in nature and is the most common way of reducing the risk of exchange rate fluctuations.
Explanation
A currency option is a way of reducing the risk by entering into a contract for buying or selling the currency at a specified price on or before the specified date. It is the most effective way of reducing the risk of exchange rate fluctuations. For example, A trader who purchased goods from a foreign country has to make payment in the currency of that country within the period specified in the contract, and for that, the trader might enter into the currency option contract so as to reduce the risk of the increased payment in future. A currency option is also the way of earning profit through hedging of the risk and through speculations. However, there are also chances of loss in the currency option contracts if the domestic currency is appreciated or foreign currency is depreciated. The fluctuation of the currency market depends upon the market conditions, which depend upon several factors.
Features of Currency Options
Features of Currency Options are as under:
- Premium: The holder of options has to pay a certain amount called a down payment or premium for having a right to exercise an options trade. The premium is non-refundable in nature. Therefore, in case the holder does not exercise the currency option, he may lose the premium.
- Validity Period: Every Currency option has a limited validity period, which means it comes with an expiration date, and the holder has to exercise the option on or before the validity period.
- Specific Price: The currency option has to be exercised at a specific price which is also called a Strike price. It is the price at which the owner of the option can buy or sell the underlying security under the contract of the option till the validity of the currency option.
- Settlement of The Option: The settlement of the option is to be done when the contract is to be exercised. There is no buying or selling of a security in the option contract is entered into.
How to Trade in Currency Options?
The currency options are traded through the stock exchanges of the respective countries. Some exchanges deal with lots of currency options which might be in multiple of 100. In addition, there are Call Options for the purchase of currency, and put option is for the sale of the currency.
Currency options are also traded through the broker. Therefore, if the trader wants to enter into a currency option for the purchase or sale of foreign currencies, it has to approach to the broker, who will charge the brokerage for entering into the contract on behalf of the trader.
Example of Currency Options
Mr. A, Resident of India, purchased the imported machinery from the USA. The cost of machinery was $ 50,000, and on the date of purchase, the exchange rate was 1$ = Rs. 60. Mr. A has to pay after 4 months. So he entered into the currency option contract today for the purchase of US dollars after 4 months at a predetermined price of 1 $ = Rs. 65. The premium paid was 1% of the transaction. The rate after 4 months was 1 $ = Rs. 62. Determine whether Mr. A should enter into a contract or not?
Solution:
Amount to be paid if exercised the option
- = $50000 * 65
- = $3,250,000
Cost of non exercising the option
- = $3,250,000 * 1%
- = $32,500
Total cost if option is not exercised
- = $50000 * 62 + 32500
- = $3,132,500
Cost if Option is exercised = $3,250,000
Cost of Option is not exercised = $3,132,500
It is advisable to not to exercise the option.
Types of Currency Options
Few Types of Currency Options are defined as under:
- Call Option: Under the Call option, the owner of the option gets the right to buy the security. The call option is not obligatory in the nature. To buy the Call Option, the owner needs to pay the price called a premium.
- Put Option: Under Put Option, the owner gets the right to sell the securities at a specific strike price within the validity of the contract. A put option is also not obligatory in nature; if the trader finds an advantage in the form of profit, he can only exercise the option. For entering into the put option, the trader has to pay the price known as the premium or purchase the put option through the broker.
Advantages
Advantages of Currency Options are as under:
- Low Cost of Entry: For entering into the currency option, the cost of entry is to be paid called a premium which is very nominal in nature.
- Risk Coverage: Currency options are the best ways to reduce the risk of foreign exchange fluctuations.
- Flexibility: Currency Options gives the purchaser the flexibility in the form of giving an option to exercise the option, which is not obligatory in nature.
Disadvantages
Disadvantages of Currency Options are as under:
- Lower Liquidity: Due to low liquidity, it is not easy to buy or sell the options.
- Risk: Though the Contract of Currency Options is to cover the risk, but if the options become unfavourable to the buyer and he does not exercise the option, he may lose the amount paid as a premium for entering into the option.
- Complicated in Nature: Currency Options are complicated in nature, especially for beginners. Also, price fluctuations are as per the market conditions, which may be favourable or unfavourable.
Conclusion
Currency Option is one of the ways to reduce the risks of exchange rate fluctuations. It is a contract for entering into an option at a specific price during the validity of the contract. There are basically two types of currency options; one is the call an option which is also called an option for buying the currency, and the other is put option, which is also called an option for selling the currency. The most important advantage of currency option is to risk coverage through hedging, the risk of exchange rate fluctuations is covered through the currency options, but the investor will lose the amount called as premium, which was paid at the time of entering into the currency options.
Recommended Articles
This is a guide to Currency Options. Here we also discuss the definition and how to trade in currency options? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –
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