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Currency options, also known as forex options, are tools designed to help businesses manage FX risks caused by fluctuating foreign currency exchange rates.

Explaining Basic Currency Options for Foreign Exchange Risk ManagementARTICLE

By Frances Coppola

Many businesses are used to managing foreign exchange risk with forward contracts. But there are additional tools designed to help businesses manage the risks caused by fluctuating foreign currency exchange rates. Currency options, also known as forex options, are one of these tools.

Options are financial derivative products which are actively traded by currency speculators, but they can also be useful hedges for international business. Sellers (or “writers”) of forex options are often big banks with large FX trading operations.

A forex option confers the right but not the obligation to buy or sell currency at an agreed exchange rate. A currency option differs from a forward contract, which locks in a future currency sale or purchase and can therefore result in FX losses if the exchange rate moves in the opposite direction from that expected. Using forex options to hedge FX risk can protect a business from adverse exchange rate movements while still allowing it to benefit from favorable ones. However, businesses often need to pay a fee to obtain the protection that an option provides.

The Essentials of Forex Options for Foreign Exchange Risk Management

An option to sell currency is called a put option: an option to buy currency is a call option. However, in the FX world, every transaction involves both the purchase and sale of a currency. So, if you wish to have the option to buy Australian dollars in exchange for U.S. dollars in three months’ time, you would enact a simultaneous three-month call option for Australian dollars and put option for U.S. dollars. This currency combination is known as a currency pair. Forex options are always enacted as put and call pairs.

The price at which you wish to buy or sell currency is called the “strike price.” For example, suppose a U.S. company has to pay a British supplier GBP10,000 in three months’ time. The company is concerned that the pound may rise against the U.S. dollar in that time, which would make that payment more expensive in dollar terms. But if the pound falls against the U.S. dollar, the company wants to benefit from this favorable exchange rate movement. So the company can buy a GBP call/U.S. dollar put option contract expiring in three months’ time at a strike price of GBP1 to $1.26, compared with a current exchange rate of $1.24. If the pound remains below $1.24, the strike price is clearly less advantageous to the U.S. company than the current exchange rate, so the option is said to be “out of the money.” But if the pound rises to $1.26 or above, the option is said to be “in the money.”

A basic forex option runs for a set period of time, such as three months. On its expiration date, if it is “in the money” then it is exercised, which means that the purchaser of the option exercises its right to buy and sell at the agreed strike price. In our example, if the GBP-U.S. dollar exchange rate has risen to $1.26, it is clearly advantageous to the U.S. company to buy GBP at the strike price, so the option will be exercised. But if the pound has fallen to $1.20, the option will typically be allowed to expire unexercised, since it is more advantageous for the U.S. company to buy GBP at the spot exchange rate.

Options come in two styles: American and European. European options can only be exercised on their expiration date. In contrast, an American option can be exercised on or before its expiration date. Since American option holders must decide whether to exercise an in-the-money option that has not yet reached its expiration date, an American option does not entirely eliminate FX risk. It does, however, potentially create greater opportunities for benefiting from favorable exchange rate movements.1

Pricing Vanilla Forex Options

In “plain vanilla” options (the simplest and most common type of option), the protection afforded by the option is analogous to an insurance contract. The writer charges the buyer a fee, known as the premium. The premium price calculation is complex and subject to change: there are many different valuation models,2 and research into options pricing is ongoing.3 In general, the premium price is based on some combination of the difference between the current market price and the strike price, the length of time until the option expires, and the probability of an exchange rate movement large enough for the option to be exercised (this is known as “implied volatility”).4 The smaller the difference between the current market rate and the strike price, the longer the time to maturity, and the higher the volatility, the more expensive the option may be.5 American-style options which give the buyer the flexibility to exercise the option before its expiry date may command a higher premium.

Of course, if the option expires unexercised, then the premium payment is lost. And even if the option is exercised, the premium effectively reduces the benefit to the buyer. The further out-of-the-money the option is when it is purchased, the cheaper it is likely to be, but the greater the likelihood that the premium will be lost.

Vanilla options are tradeable instruments whose price may change daily. International hedge accounting standards require them to be carried on a company’s accounts at “fair value,” which means they must periodically be revalued to market price (“marked to market”).6 The fact that an option’s price can change frequently creates a risk of losses for both the seller and the buyer from adverse movements in the market price of the option – this is known as “market risk.”7 Adverse movements in the underlying currency exchange rate also create the risk that the seller will be unable to settle the buyer’s claim on exercise of the option – this is “settlement risk.”8

When options are traded on recognized exchanges such as the Chicago Board Options Exchange (“exchange-traded options”),9 the exchange itself is the counterparty to each trade. So if sellers default due to heavy losses, the exchange must still honor its contracts with the buyers. To protect the exchange from losses, therefore, sellers of vanilla options are required to lodge with the exchange an initial margin or “collateral” which covers a percentage of the initial value of the option, and they must also post at the exchange the cash equivalent of the daily change in price – this is known as “variation” or “cash” margin. This is standard practice for exchange-traded options across all asset classes.10

However, the forex options market is mostly “over the counter” (OTC), which means that sellers and buyers of options trade directly with each other rather than on exchanges. Since the financial crisis of 2007-2009, clearing of OTC derivatives including forex options has increasingly been undertaken through central clearing houses, known as central counterparties (CCPs).11 CCPs protect buyers of derivatives, including options, from the possibility of default by the seller in a large price movement. Typically, they require initial and variation margins to be posted, which helps to ensure that CCPs always have sufficient resources to clear trades. 12

The Takeaway

Forex options provide an additional tool for foreign exchange risk management, alongside other commonly used tools such as forward contracts. Options are simple in principle, but their pricing can be complex. Familiarity with the terminology and the basic principles of options trading may be helpful when understanding ways to hedge FX risk in international business.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. "Currency Options Explained", ForexTraders; http://www.forextraders.com/forex-analysis/forex-fundamental-analysis/currency-options-explained.html
2. "Options pricing: Modeling", Investopedia; http://www.investopedia.com/university/options-pricing/modeling.asp
3. "Gated Neural Networks for Option Pricing: Rationality by Design" ,Yang, Zheng & Hospedales; https://arxiv.org/abs/1609.07472
4."Implied Volatility IV", Investopedia; http://www.investopedia.com/terms/i/iv.asp
5. "Getting a handle on the Option Premium", Investopedia; http://www.investopedia.com/articles/active-trading/112213/getting-handle-options-premium.asp
6. "International Financial Reporting Standards: IAS 39" “Achieving hedge accounting in practice", PriceWaterhouseCoopers; https://www.pwc.com/gx/en/ifrs-reporting/pdf/ias39hedging.pdf
7. "Market Risk", Investopedia; http://www.investopedia.com/terms/m/marketrisk.asp
8. "Supervisory guidance for managing settlement risk in foreign exchange transactions", Bank for International Settlements; http://www.bis.org/publ/bcbsc1310.pdf
9. "Options Exchange Listing", Stock Options Made; http://www.stock-options-made-easy.com/options-exchange.html
10. Margin Manual,CBOE; http://www.cboe.com/learncenter/pdf/margin2-00.pdf
11. "Over-the-counter (OTC) derivatives, central clearing and financial stability", Bank of England; http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2015/q306.pdf
12. "How does clearing work?", European Association of Clearing Houses; http://www.eachccp.eu/wp-content/uploads/2015/12/Website-presentation-EACH.pdf

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