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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 specified currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller, the amount of which varies 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 on the over-the-counter market. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.

BREAKING DOWN 'Currency Option'

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 that sells a put then has the obligation to buy the currency, while the seller of a call has the obligation to buy it.

Basics

Options pricing has several components. The strike is the rate at which the owner of the option is able to buy the currency, if the investor is long a call, or sell it, if the investor is long 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. Depending on the type of the option and where the spot rate is trading, in relation to the strike, the option is exercised or expires worthless. If the option expires in the money, the currency option is cash settled. If the option expires out of the money, it expires worthless.

Example

Assume an investor is bullish on the euro and believes it will increase against the U.S. dollar. Therefore, the investor purchases a currency call option on the euro with a strike price of $115, since currency prices are quoted as 100 times the exchange rate. When the investor purchases the contract, the spot rate of the euro is equivalent to $110. Assume the euro's spot price at the expiration date is $118. Consequently, the currency option is said to have expired in the money. Therefore, the investor's profit is $300, or (100 * ($118 - $115)), less the premium paid for the currency call option.

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