Foreign Currency Options

Foreign Currency Options

Foreign Currency Options are a more flexible way of obtaining protection against currency rate shifts. The key difference between these and the Forward Currency Contract is that the customer is not obliged to take up the option if it is not advantageous to do so. This arrangement with the Bank confers a right but not an obligation to buy or sell currency at an agreed rate. If the currency moves in the trader’s favor during the option period, then the option can simply be allowed to lapse. It does, however, provide all-important protection against adverse currency rate fluctuations. If these should occur, the option is available to be exercised.

Foreign Currency Options are also useful for businesses who may require an amount of a foreign currency at some date in the future but cannot be sure of this – for example during the negotiation of prices for an international deal which take into account a known rate of exchange. If the deal goes ahead, the guaranteed rate could be improved upon, but could never be worse than the option rate. If the deal falls through, the option can be allowed to lapse. There are two basic types of option available from banks in this respect.

European Style Option, is a deal where the exercise date otherwise known as the Strike Date is fixed, and is the only date upon which the option can be taken up.

American Style Option can be exercised at any time up to the strike date, after which it, too, expires.

As you would expect, there is a price, known as the premium, which is paid up-front to the Bank at the time the option is arranged. This is usually quoted as a percentage of the currency amount, and will be a function of the ‘strike’ rate agreed, the option period and type as well as the Bank’s assessment of the volatility of the currencies involved and the interest rate differentials between them. Let us assume, for example that the worst rate an exporter is prepared to accept is $1.65 when exchanging the proceeds of his sale (in Dollars) for Pounds Sterling.

In order to protect himself against a worse rate, he may decide to buy an ’American style’ currency option to sell One million US Dollars at a ‘strike price’ of $1.65 for expiry in, say, six months time. If, at any time during this period, the market (‘spot’) rate is worse than $1.65 the option can be exercised and the dollars sold at $1.65 through the Bank. Alternatively, if the market rate is better than $1.65 the option can be allowed to lapse and the Dollars sold in the market at the ‘spot’ rate.

Traders regularly working in particular foreign currencies will normally operate foreign currency accounts through their banks so that they can hold sums of one or more currency without being forced to buy or sell at a possible disadvantage at the time they receive or make payments. It should be noted, however, that some countries, in order to protect their own currencies, will impose restrictions on the use of foreign currency accounts and permission may have to be sought from government departments to but or sell currencies.