In this article, We learn about "Currency Option ".Let's Go!
A Currency Option is a contract in which the seller provides the buyer with the right (but not the obligation) to buy or sell a specific currency at a specified exchange rate on or before a fixed date.
Currency options are financial derivatives. Its value is "derived" from the underlying asset. In this case a specific currency pair.
Call option allows the holder to buy a currency pair at a specified price within a specified time frame. put option allows the holder to sell a currency pair at a specified price within a specified time frame.
Foreign currency options have several key components.
- Premium is the price an option buyer pays for the right to buy or sell that currency at a fixed interest rate on or before a specific expiration date.
- Strike Price is the rate at which a currency is bought or sold by the maturity date.
A Japanese company with USD/JPY exposure can purchase currency options with an expiration date six months from now to protect themselves against any adverse currency movements (if they have USD payments on that date) .
If the strike price is more favorable than the spot rate on the expiration date of the option, the option will expire "in the money" ("ITM") and the holder shall exercise the option.
However, if the exchange rate on the maturity date is better than the exercise price, the holder will not exercise the option. In this case, the option will expire " Out of the Money " ("OTM").
While currency options are one of the hedging tools available to businesses, in reality, they are primarily used for speculation.
Currency traders exploit options to make money by buying them and simultaneously exchanging them for cash in the spot market to earn the difference.