The currency options market shares its origins with the new markets in derivative products, which have blossomed in recent years. They were developed to cope with the rise in volatility in the financial markets world wide. In the foreign exchange markets, the dramatic rise (1983–1985) and the subsequent fall (1985–1987) in the dollar caused major problems for central banks, corporate treasurers, and international investors alike. Windfall foreign exchange losses became enormous for the treasurer who failed to hedge, or who hedged too soon, or who borrowed money in the wrong currency. The investors in the international bond market soon discovered that the risk on their bond positions could appear insignificant relative to their currency exposure. Therefore, currency options were developed, not as another interesting off-balance-sheet trading vehicle but as an alternative risk management tool to the spot and forward foreign exchange markets. They are a product of currency market volatility and owe their existence to the demands of foreign exchange users for alternative hedging and exposure management techniques.
DEFINITIONS
A foreign exchange option gives the holder the right, but not the obligation, to buy or sell a certain currency against another, at a certain rate and at/by a certain date in the future.
The most important factor of an option, in comparison to a foreign exchange transaction, is that the buyer has the right, but not the obligation, to buy or sell a specified quantity of a currency at a specified rate on or before a specified date. For this right, the buyer pays a premium to the seller or writer of the currency option, usually at the outset. For currency options, the premium is often expressed as a percentage of the notional amount covered. The essential characteristics of a currency option for its owner are those of risk limitation and unlimited profit potential.
It is similar to an insurance policy. Instead of an individual paying a premium and insuring a house against fire risk, a company pays a premium to insure itself against adverse foreign exchange risk movements. This premium is the buyer’s maximum cost.
The terms used in the options market can be confusing, but the principle terms or jargon
used can be summarized as follows.
- The option buyer is called the buyer and the option seller the writer.
- A call gives the buyer the right to buy a specific quantity of a currency at an agreed rate over a given period.
- A put gives the buyer the right to sell a specific quantity of a currency at an agreed rate over a given period.
- The premium is the price paid for the option. With a currency option this can be expressed
- in different ways and is usually paid with spot value from the initial deal date.
- The principle amount is the amount of currency which the buyer can buy or sell.
- Exercise is the process by which the option is converted into an underlying foreign exchange contract.
- The strike price or exercise rate is the exchange rate at which the option may be exercised.
- Expiry date is the final date on which the option may be exercised.
- A European style option can be exercised at any time but the funds will be transferred on the maturity date. In practice, most European style options are not exercised until the expiry date.
- An American style option can be exercised at any time up to and including the expiry date with the funds being transferred with spot value from exercise.
It is important to note that, due to the nature of foreign exchange, all currency options are a put on one currency and a call on another. For example, a dollar call/Swiss franc put gives the buyer the right to buy dollars and the right to sell Swiss francs.
Source: A Foreign Exchange Primer
