As Figure 14.3 shows, there is one very important factor to remember regarding currency options: for the buyer of an option, the maximum risk is limited to the premium paid, but for the option seller, the maximum profit is limited to the premium received and the seller is potentially exposed to unlimited losses. Additionally, because of the credit risk involved when writing options, there are typically fewer restrictions on those wishing to buy options than on those wishing to sell.
Writing options on exchanges tends to be simpler as the credit risks are controlled by a margin system. The margin is a small percentage of the value of the contract, which must be deposited to cover losses up to a certain limit. The margin is usually adjusted on each trading day and, on occasions, more frequently to take account of market movements. However, the greater flexibility available in the OTC market allows some of the credit difficulties to be pursued and overcome. Participants in the foreign exchange currency options market include:
- Banks – who provide a service for their clients, to manage their own foreign exchange risk, and in order to take a directional and/or volatility view.
- Supranationals and sovereigns – all issuers of debt in foreign currencies will have exchange rate exposure, which must be managed.
- Multinational companies – multinationals and their subsidiaries will have funds and crossborder transactions in several currencies and so will be subject to foreign exchange risk.
- Importers and exporters – any company that imports or exports goods to a foreign country will have exposure to fluctuations in exchange rates.
- Investors in foreign currency securities – investors in foreign securities will be exposed to fluctuations in the currency in which the securities are denominated.
- High net worth individuals – such individuals may use exchange-traded currency options for speculation on exchange rates because of the gearing they offer.
For example, a British-based company exports consumer goods to several countries. Currently, the company has contracted to supply 10 million dollarsworth of goods to America and expects to receive payment in three months’ time, in dollars. The company believes that the dollar will appreciate against sterling over the next three months.
There are several alternative strategies. The company can:
(1) leave the future cash flow unhedged in the belief that the exchange rate will move in their favour;
(2) enter into a forward contract to sell dollars and buy sterling in three months’ time;
(3) purchase a 3-month sterling call option (the right to buy sterling and sell dollars).
Possible results:
- If the exchange rate does move in the company’s favour, then the company will receive a windfall profit on its long dollar position. However, this strategy is very dangerous because if the exchange rate moves contrary to the company’s expectations, its sterling profits will be reduced and could become a loss as its costs are fixed in sterling.
- If the company enters into a forward contract, it is locking in an exchange rate for the supply deal. This gives the company protection against a dollar depreciation but does not allow it to take any profit from a dollar appreciation, which is contrary to its expectations for the exchange rate.
- If the company purchases a sterling call option, this will require the company to pay out a premium upfront. However, it will guarantee the company a minimum exchange rate for the supply contract. It allows the company to indulge its expectations that the dollar will appreciate from current levels as, should this expected appreciation occur, the company is free to abandon the option and transact in the market at the more favourable exchange rate.
If the company decides to purchase a currency option, it could buy a 3-month option, a European-style sterling call/dollar put option, with a strike price of £/$1.75 (that is, the right to buy sterling and sell dollars at a rate of £/$1.75). Assume the cost of the option is 1.74% of the sterling amount, i.e. £99 428.57 ($10 000 000 divided by 1.75 equals £5 714 285.71 × 1.74%).
Source: A Foreign Exchange Primer
