Currency Options



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Derivatives are one of the most complex financial products to be understood. Options form an integral part of these products. An option gives the holder or the buyer of the option, the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. This means that a buyer of the option has the right to buy while the seller of the option has the obligation to deliver. In currency options the underlying asset is the currency. Another term for Currency Options is 'Forex Options'. Forex stands for "foreign exchange"

 

If by now you are too addled, the reason is that options are a complex derivative product. So let us try to explain it in a more simplified manner. But for that we would need to get some understanding of futures (another derivative product). In futures, today you take a view of what will happen in the future and both buyer and seller have to perform accordingly when the day of delivery comes i.e. both have the obligation to perform.

For instance: standing today buyer of the future thinks that price of one packet of rice would rise to $1.4 in three months. The price of rice today is $1. The seller is of the view that the price would fall to $0.8 in three months. The buyer enters into a contract with the seller that he would pay $1.2 for one packet of rice after three months. As the seller is of the view that prices would fall, he accepts the contract. Now on the delivery day, actual spot price of the rice is $0.9. So, the buyer of the futures contract loses $0.3 while the seller makes the delivery at $1.2 and makes the profit. So, here we see that a futures contract is binding for both the buyer and the seller.

But in the options the contract is binding only on the seller of the option. There are two types of options: call and put option. The buyer of the call option has the option to buy a given quantity of asset at some time in the future, at prices agreed upon today while the buyer of the put option has the option to sell a given quantity of asset at some time in the future, at prices agreed upon today.

 Let us try to understand the options with an example. A buyer of call option buys an index for $560 whose delivery is after 1 week. Today, the spot price of index is at $540.The premium paid upfront by the buyer of the option is $8. Now if on the delivery date, the market moves downward and index is priced at $500, the buyer of the option will not exercise his option and make a loss of $8 that is the upfront premium. But if the market moves up to $600, the buyer will exercise the call option and the profit of the buyer of the option will be huge. So, we see that the buyer of the option has limited losses if his view is wrong while unlimited gains if his view is right. Owing to this reason, options are a very popular means of hedging. And as they offer a very high degree of leverage, they attract speculators too.

Currency options are one of the types of options. All the terms of the contract are same.They have a delivery price of the underlying asset called strike price. Today’s price in the market is spot price. The upfront payment made to buy the option is called premium. The contract has a certain expiry date or maturity date when the delivery shall take place. Consider the USD call option on Dollar/Rs therefore it becomes put option on Indian rupee. The face amount in dollars $10,000,000 and option expires in 3 months. The strike price is Rs.45.00.It grants its owner the right but not the obligation to receive $10,000,000 in exchange for delivery of Rs.450,000,000 at option expiration. This option should be exercised if the spot exchange rate is above Rs.45.00 on the expiration date to make profits. If the spot exchange rate is lower, there will be loss of the upfront premium.

I hope this article explains basics of currency options.