Average Rate Option - ARO


DEFINITION of 'Average Rate Option - ARO'

An option used to hedge against fluctuations in exchange rates by averaging the spot rates over the life of the option and comparing that to the strike price of the option. Average rate options are typically purchased for daily, weekly or monthly time periods. Upon maturity, the average of the spot prices is compared to the strike price. If the average rate is less favorable than the strike price, the option issuer will pay the difference. If the average rate is more favorable then the option will expire worthless with no payment being made.

Average rate options are often used by companies that receive payments over time that are denominated in a foreign currency.

BREAKING DOWN 'Average Rate Option - ARO'

For example, a U.S. manufacturer agrees to import materials from a Chinese company for 12 months, and pays the supplier in yuan. The monthly payment is 50,000 yuan. The manufacturer budgets for a particular exchange rate, and purchases an ARO that matures in 12 months to hedge against the exchange rate falling below the budgeted level. At the end of each month, the manufacturer purchases 50,000 yuan on the spot market to pay the supplier. Upon maturity of the ARO, the strike price of the ARO is compared to the average rate that the manufacturer has paid for the purchase of 50,000 yuan. If the average is lower than the strike, the option issuer will pay the manufacturer the difference between the strike price and average price.

  1. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  2. Exchange Rate

    The price of a nation’s currency in terms of another currency. ...
  3. Option

    A financial derivative that represents a contract sold by one ...
  4. Strike Price

    The price at which a specific derivative contract can be exercised. ...
  5. Spot Price

    The current price at which a particular security can be bought ...
  6. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
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