CURRENCY OPTIONS
A foreign currency option required the payment of a premium in exchange for a right to use one currency to buy another currency at a specified price on or before a specified date. A call option permits the buyer to sell the underlying currency at the strike price.
An option is easier to manage than a forward exchange contract, because a company can choose not to exercise its option to sell currency if a customer does not pay it. Not exercising an option is also useful when it becomes apparent that a company can realize a gain on changes in the exchange rate, which would not have been the case if it were tied into a forward exchange contract.
Options are especially useful for those companies interested in bidding on contracts that will be paid in a foreign currency. If they do not win the bid, they can simply let the option expire, without any obligation to purchase currency. If they win the bid, then they have the option of taking advantage of the exchange rate that they locked in at the time they formulated the bid. Thus, options allow a company to realize the original margin that they quoted to a customer, rather than potentially having the margin erode due to exchange risk.
In an option agreement, the cost to the buyer is fixed up front, while the cost to the seller is potentially unlimited – which tends to increase the cost of the option to the point where the seller is willing to take on the risk associated with the contract. From the seller’s perspective, the amount of an option premium is based on the strike price, time to expiration, and the volatility of the underlying currency. If the currency is highly volatile, then it is more likely that the buyer will exercise the option, which increases the risk for the seller. Thus, an option for a nonvolatile currency is less expensive, since it is unlikely to be exercised.
Currency options are available over – the – counter and are traded on exchanges. Those traded on exchanges are known as listed options. The contract value, term, and strike price of a listed of listed option is standardized, whereas these terms are customized for an over – the – counter option.
Within an option agreement, the strike price states the exchange rate at which the underlying currency can be bought or sold, the notional contract amount is the amount of currency that can be bought or sold at the option of the buyer and the expiry date is the date when the contract will expire, if not previously exercised. If the option is in- the – money, then the buyer can exercise it at a better price than the current exchange rate. If the option is at – the – money, then the buyer can only exercise it at an exchange rate that is worse than the market rate. A European – style option is only exercisable on the expiry date. While an American – style option can be exercised at any time prior to and including the expiry date.
The problem with an option is that it requires the payment of an up – front premium to purchase the option, so not exercising the option means that the fee is lost. This is fine if a gain from currency appreciation offsets the fee, but is an outright loss if the non exercise was caused by the customer not paying on time.
A more complicated version of the option is the foreign exchange collar. Under this strategy, a company buys one option and sells another at the same time, using the same expiry date and the same currencies. Doing so establishes an exchange rate range for a company. The upper limit of the exchange rate is established by the option the company buys, while the lower limit is established by the option that the company sells. If the exchange rate remains within the upper and lower price points of the collar, then neither option is exercised. By accepting a moderate range of acceptable prices, a company can offset the cost of the premium paid for the purchased option with the premium from the option that is sold. The option are usually European – style, so they are only excised on the expiry date.
Another issue with options is that they must be marked to market at the end of every reporting period, with the gain or loss recorded in the company’s financial statements.