The essential characteristics of a currency option for its owner are those of risk limitation and unlimited profit potential. It is similar to an insurance policy, whereby instead of a householder paying a premium for insuring the house against fire risk, a company pays a premium to insure itself against adverse foreign exchange risk movement. This premium is paid upfront and is the company’s maximum cost. Exchange of currencies in the future may take place at the strike price or, if it is more beneficial, at the prevailing exchange rate.
Options can be obtained directly from banks, known as over-the-counter (OTC) options, or via brokers from an exchange (exchange traded options). The essential characteristics of over-the-counter options are their flexibility. The buyer can choose the currencies, time period, strike price and the contract size, in order to match the particular exposure requirements at the time. Against this, exchange traded options have standardised time periods and strike prices and only a certain number of currencies are traded, thus limiting choice. This standardisation of option contracts promotes tradability, but this is at the expense of flexibility.
The main users of options are organisations whose business involves foreign exchange risk and may be a suitable means of removing that foreign exchange risk instead of using forward foreign exchange. Against this, in general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers. The over-the-counter option market has as its market makers banks, who sometimes use the exchanges to offset risk.
Options can be and are used in many different circumstances, but essentially in times of uncertainty. For example, a British company wanting to make an acquisition in Japan is faced with a possible uncertainty in the timing of a foreign exchange cash flow. The British company does not know exactly when the acquisition will take place as there are so many factors to be put in place, but it does know that at some stage the company will have to buy Japanese yen and sell sterling. The foreign exchange risk is obviously key to a successful acquisition. By using a currency option, the treasurer would know exactly the maximum cost of the acquisition but would also have the potential for greater profit if the Japanese yen weakened.
Another example would be in a tender-to-contract situation, where a company is uncertain as to whether there will be an exposure at all. By using options, the company will know with certainty the worst rate at which it can exchange one currency for another should the company win the contract. If the exchange rate moves in its favour, the company can deal at the better prevailing rate. If, however, the company loses the contract, it will either have lost the premium, which is a known cost paid upfront, or it may have the potential for gain if the prevailing exchange rate is better than the rate agreed under the option.
Thus, normal foreign exchange transaction risk obviously gives rise to uncertainty. Using options as an insurance policy can result in peace of mind for the user. The cost, the premium, is
known and paid upfront. The treasurer then knows what the worst rate would be and can budget accordingly knowing that there may be a windfall gain. Translation risk is always a difficult problem for a company. If an unrealised exposure is hedged using an option, the maximum cost is known upfront. If it is hedged using a foreign exchange forward, then there is potential for a realised loss when the foreword contract is rolled.
Options can be obtained directly from banks, known as over-the-counter (OTC) options, or via brokers from an exchange (exchange traded options). The essential characteristics of over-the-counter options are their flexibility. The buyer can choose the currencies, time period, strike price and the contract size, in order to match the particular exposure requirements at the time. Against this, exchange traded options have standardised time periods and strike prices and only a certain number of currencies are traded, thus limiting choice. This standardisation of option contracts promotes tradability, but this is at the expense of flexibility.
The main users of options are organisations whose business involves foreign exchange risk and may be a suitable means of removing that foreign exchange risk instead of using forward foreign exchange. Against this, in general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers. The over-the-counter option market has as its market makers banks, who sometimes use the exchanges to offset risk.
Options can be and are used in many different circumstances, but essentially in times of uncertainty. For example, a British company wanting to make an acquisition in Japan is faced with a possible uncertainty in the timing of a foreign exchange cash flow. The British company does not know exactly when the acquisition will take place as there are so many factors to be put in place, but it does know that at some stage the company will have to buy Japanese yen and sell sterling. The foreign exchange risk is obviously key to a successful acquisition. By using a currency option, the treasurer would know exactly the maximum cost of the acquisition but would also have the potential for greater profit if the Japanese yen weakened.
Another example would be in a tender-to-contract situation, where a company is uncertain as to whether there will be an exposure at all. By using options, the company will know with certainty the worst rate at which it can exchange one currency for another should the company win the contract. If the exchange rate moves in its favour, the company can deal at the better prevailing rate. If, however, the company loses the contract, it will either have lost the premium, which is a known cost paid upfront, or it may have the potential for gain if the prevailing exchange rate is better than the rate agreed under the option.
Thus, normal foreign exchange transaction risk obviously gives rise to uncertainty. Using options as an insurance policy can result in peace of mind for the user. The cost, the premium, is
known and paid upfront. The treasurer then knows what the worst rate would be and can budget accordingly knowing that there may be a windfall gain. Translation risk is always a difficult problem for a company. If an unrealised exposure is hedged using an option, the maximum cost is known upfront. If it is hedged using a foreign exchange forward, then there is potential for a realised loss when the foreword contract is rolled.
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