The users of the option market are widespread and varied, but the main users are organisations
whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers, where the standardisation of options contracts promotes tradability, but this is at the expense of flexibility.
In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options as a means to managing currency exposures. Some clients consider options to be expensive and/or speculative. When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimise downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option, instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements.
Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.
Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.
Hence, in buying a currency option, it may help the purchaser by:
Limiting downside currency fluctuation risk while retaining upside potential;
Providing unlimited potential for gain;
Providing a hedge for a contingent risk; and
Enable planning with more certainty.
Selling currency options may assist the writer (seller) by:
Providing immediate income from the premium received; and
Providing flexibility when used with other tools as part of an exchange rate strategy.
For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By buying a call (the right to buy) the maximum cost can be fixed for a purchase and by purchasing a put (the right to sell) the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavourable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favourable moves.
In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from expecting volatility either to increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of $/sfr 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months’ time.
The trader has two choices:
whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers, where the standardisation of options contracts promotes tradability, but this is at the expense of flexibility.
In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options as a means to managing currency exposures. Some clients consider options to be expensive and/or speculative. When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimise downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option, instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements.
Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.
Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.
Hence, in buying a currency option, it may help the purchaser by:
Limiting downside currency fluctuation risk while retaining upside potential;
Providing unlimited potential for gain;
Providing a hedge for a contingent risk; and
Enable planning with more certainty.
Selling currency options may assist the writer (seller) by:
Providing immediate income from the premium received; and
Providing flexibility when used with other tools as part of an exchange rate strategy.
For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By buying a call (the right to buy) the maximum cost can be fixed for a purchase and by purchasing a put (the right to sell) the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavourable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favourable moves.
In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from expecting volatility either to increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of $/sfr 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months’ time.
The trader has two choices:
- To hold the option to expiry and if the spot rate has risen to, for example, $/sfr 1.73, the trader would exercise his right to buy dollars and sell Swiss francs at 1.6835, and hence, make money. If the spot rate is below $/sfr 1.6835 at expiry, then the maximum loss is limited to the premium paid for the option.
- Alternatively, if the spot rate rises, say one month after the trader has purchased the option,the trader could choose to sell the option back. By doing this, the trader will recoup both the time value and intrinsic value of the option.
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