Currency Option

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What is a 'Currency Option'

A currency option is a contract that grants the buyer the right, but not the obligation, to buy or sell a given currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the seller, the amount of which will vary depending on the number of contracts if the option is bought on an exchange, or on the nominal amount of the option, if it is done in the over-the-counter market.

BREAKING DOWN 'Currency Option'

Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates. Options can also be used to take speculative positions.

Investors can hedge against foreign currency risk by purchasing a currency put or call. Buying a put gives the holder the right but not the obligation to sell a currency at a stipulated rate by a given date; a call is the right to buy the currency. An investor who does not have an underlying exposure can take a speculative position in a currency by buying or selling a put or call. A person or institution who sells a put then has the obligation to buy the currency, while the seller of a call has the obligation to buy it.

Pricing Basics

Options pricing has several components. The strike is the rate at which the owner of the option will be able to buy the currency (if he owns a call) or sell it (if he owns a put). At the expiration date of the option, which is sometimes referred to as the maturity date, the strike price is compared to the then-current spot rate. If the strike price is better than the price in the market, the owner can execute the option and take (or make) delivery of the currency. If the strike is worse than the price in the market, the option expires worthless. The settlement date is usually two business days after expiration (or one day for Canadian dollars).

The closer the strike is to the market forward price for the expiration date when the option is first purchased, the more expensive the option will be. Higher volatility, which is a measure of how much the market is moving, will make an option more expensive because there is a greater likelihood that it will expire in the money, meaning that it can be exercised.

An option with a longer period to maturity costs more than one with a shorter period to maturity.

Exercise

An American-style option can be exercised on any valid trading day up to and including the expiration date, while European-style options can only be exercised on their maturity date.

Intrinsic Value

An option increases in value as the market rate approaches the strike price and/or if volatility increases. An option can be sold for its intrinsic value to another investor or to the counterparty from which it was purchased.

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