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.
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. An option to sell currency is called a put 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. This currency combination is known as a currency pair. Forex options are always enacted as put and call pairs.
The company is concerned that the pound may rise against the U. But if the pound falls against the U. A basic forex option runs for a set period of time, such as three months. In our example, if the GBP-U. Options come in two styles: 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. The writer charges the buyer a fee, known as the premium.
The premium price calculation is complex and subject to change: 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. So if sellers default due to heavy losses, the exchange must still honor its contracts with the buyers.
This is standard practice for exchange-traded options across all asset classes. Since the financial crisis of , clearing of OTC derivatives including forex options has increasingly been undertaken through central clearing houses, known as central counterparties CCPs. Typically, they require initial and variation margins to be posted, which helps to ensure that CCPs always have sufficient resources to clear trades. 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. 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. Article s on this website that are identified as being prepared by third parties are made available to you for information purposes only. These third party articles do not represent the opinions, views or analysis of American Express and American Express does not make any representations as to their accuracy or completeness. If you have questions about the matters discussed in those articles, please consult your own legal, tax and financial advisors.
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