What is an Average Rate Option (ARO)
An average rate option (ARO) is an option used to hedge against fluctuations in exchange rates by averaging the spot rates over the life of the option and using that value as the option’s strike price.
BREAKING DOWN Average Rate Option (ARO)
Average rate options are a type of exotic option that involves averaging a currency rate over a period of time to determine the exercise price at expiration. Average rate options are also valued as a type of European option since the exercise can only be done at expiration.
Average Rate Option Considerations
Average rate exotic options can be used to hedge various types of assets. Average strike options are popular for hedging the volatility of a stock over a specified period of time. Other average options also exist. As exotic options, average rate options are traded on alternative exchanges and not listed on regulated public market exchanges. Thus, institutional investors are the most common traders of these options because of their complexity. Institutional investors also have the capability to develop and orchestrate average rate options through detailed contracts and provisions that can protect them from replacement risk. Replacement or recovery risks can be a significant factor with these options since they are not regulated and supported by regulatory authorities such as the Options Clearing Corporation (OCC) or the Commodity Futures Trading Commission (CFTC).
Average Rate Option Construction
Average rate options are typically purchased for daily, weekly or monthly time periods. They are a type of European option since they can only be exercised at expiration. Investors in average rate options pay for rights to the option. At the option’s expiration the exercise price available is the average rate of the option from the initial entrance of the option to the expiration of the option. Upon maturity, the average of the spot prices is compared to the strike price.
Average rate options are often used by companies that receive payments over time that are denominated in a foreign currency. 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 manufacturer will exercise the option and the issuer will pay the manufacturer the difference between the strike price and average price.