Average Rate Option - ARO

AAA

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.

INVESTOPEDIA EXPLAINS '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.




RELATED TERMS
  1. Exchange Rate

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

    A financial derivative that represents a contract sold by one ...
  3. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  4. Spot Price

    The current price at which a particular security can be bought ...
  5. Strike Price

    The price at which a specific derivative contract can be exercised. ...
  6. Exchange Traded Derivative

    A financial instrument whose value is based on the value of another ...
RELATED FAQS
  1. What does it mean to roll a derivative contract?

    A derivative is a financial instrument in which the price of the derivative is dependent on an underlying asset. A derivative ... Read Full Answer >>
  2. How can derivatives be used for risk management?

    Derivatives could be used in risk management by hedging a position to protect against the risk of an adverse move in an asset. ... Read Full Answer >>
  3. How can I profit from monitoring open interest?

    Since markets experience asymmetric information between parties, monitor whether there is an imbalance between the open interest ... Read Full Answer >>
  4. Why would a company issue a rights offering?

    Companies most commonly issue a rights offering to raise additional capital. A company may need extra capital to meet its ... Read Full Answer >>
  5. What is the difference between share purchase rights and options?

    There is a big difference between share purchase rights and options. With share purchase rights, the holder may or may not ... Read Full Answer >>
  6. What is the difference between an option-adjusted spread and a Z-spread in reference ...

    Unlike the Z-spread calculation, the option-adjusted spread takes into account how the embedded option in a bond can change ... Read Full Answer >>
Related Articles
  1. Forex Fundamentals

    What Causes A Currency Crisis?

    Find out what can cause a currency to collapse, and what central banks can do to help.
  2. Options & Futures

    Hedging Basics: What Is A Hedge?

    This strategy is widely misunderstood, but it's not as complicated as you may think.
  3. Forex Education

    How To Profit From Interventions In The Forex Market

    The forex market can be extremely profitable. Learn how to spot an intervention and trade when it's occurring.
  4. Forex Education

    Global Trade And The Currency Market

    Learn how the Bretton Woods system got the ball rolling for world trade.
  5. Active Trading

    How Companies Use Derivatives To Hedge Risk

    Derivatives can reduce the risks associated with changes in foreign exchange rates, interest rates and commodity prices.
  6. Bonds & Fixed Income

    6 Factors That Influence Exchange Rates

    Find out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  7. Investing

    What More Volatility Means For Momentum Stocks

    One byproduct of the recent tick higher in bond yields: a meaningful rise in volatility for both stocks and bonds.
  8. Options & Futures

    How & Why Interest Rates Affect Options

    The Fed is expected to change interest rates soon. We explain how a change in interest rates impacts option valuations.
  9. Investing Basics

    Understanding Notional Value

    This term is commonly used in the options, futures and currency markets because a very small amount of invested money can control a large position.
  10. Options & Futures

    The Risks Of Writing Covered Calls

    While writing a covered call option is less risky than writing a naked call option, the strategy is not entirely riskfree.

You May Also Like

Hot Definitions
  1. Covered Call

    An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset ...
  2. Butterfly Spread

    A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration ...
  3. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
  4. Moving Average - MA

    A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
Trading Center