Average Rate Option (ARO)

What Is an Average Rate Option (ARO)?

An average rate option (ARO) is a currency exchange derivative product that is used by traders who seek to hedge against fluctuations in exchange rates. The strike price for average rate options is set at the time of the option's expiration by averaging spot rates over the life of the option.

The average rate option is known as an exotic option rather than a traditional option because of this variable strike price. It also is known as a type of European option because the ability to exercise the right to buy or sell the underlying asset is limited to the date of its expiration.

Understanding Average Rate Options

The process of trading in average rate options begins with a buyer and seller committing to foreign exchange currency options at a set strike price on a set schedule. The buyer pays a premium for the option. During the predetermined time limit, the buyer will purchase the same currency pair on the market with a defined maturity date. At the expiration date, the strike price is compared to the average price of the currency pair during the period of the contract. If the average price is lower than the strike price, the seller will pay the buyer the difference. If the price is higher, the option expires worthless.

Who Buys Average Rate Options

Average rate options are often used by companies that trade internationally and thus pay or receive payments over time that are denominated in a foreign currency.

For example, a U.S. manufacturer may agree to import materials from a Chinese supplier for 12 months and to pay the supplier in yuan. The monthly payment is 50,000 yuan. The American business thus faces the risk that the yuan will increase in value over the U.S. dollar, inflating its costs and eroding its profits from the agreement.

The manufacturer deals with the problem by budgeting for a particular exchange rate and then purchasing an ARO that matures in 12 months. That is a hedge against the chance that the dollar exchange rate will fall 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.

Other Average Options

Other average options exist to hedge against other risks. Average strike options, for example, are popular for hedging the volatility of a stock's price over a specific period of time.

The purpose of an average option is to smooth out a potential source of volatility in some aspect of a business. The volatility may be in the demand for a product, in the value of the currency it is traded in, or in the liquidity of the underlying asset. As a category, these products are sometimes known as Asian options.

As exotic options, average rate options are traded on alternative exchanges and are not listed on regulated public market exchanges. Thus, institutional investors are the most common traders of these options.

Institutional investors also have the capability to develop and orchestrate average rate options through detailed contracts and provisions that 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).