A currency option is a financial derivative contract that gives the buyer the right, but not the obligation, to buy or sell a specific amount of foreign currency at a predetermined exchange rate (known as the strike price) on or before a specified expiration date. To obtain this right, the buyer pays a premium to the seller of the option.
Currency options are commonly used by corporations, investors, and financial institutions to hedge against adverse movements in exchange rates or to speculate on currency fluctuations. There are two main types:
These contracts can be structured as "American" options (exercisable at any time up to expiration) or "European" options (exercisable only at expiration). If the option is beneficial at expiration (i.e., the spot rate is better than the strike price for the buyer), it is said to be "in the money" and may be exercised for a profit; otherwise, it expires worthless and only the premium is lost.
Example of a Currency Option
Scenario:
Suppose a U.S. company expects to receive €100,000 (euros) in three months from a European customer. The company is concerned that the euro might depreciate against the U.S. dollar, reducing the value of its receivable when converted to dollars.
Solution:
The company buys a euro put option (the right to sell euros for dollars) with the following terms:
Possible Outcomes
1. Euro Falls Below $1.10 (e.g., $1.05)
2. Euro Rises Above $1.10 (e.g., $1.15)