What is an FX Option?
An FX Option is a contract that confers on the holder the right – but not the obligation – to exchange an amount of one currency for another at a pre-agreed rate (the ‘strike’ rate) on a pre-agreed date.
The purpose of an FX Option is to place a maximum (or minimum) exchange rate on a known transaction of a different currency in the future, thereby limiting the potential downside but maintaining the ability to exchange at a more favourable rate should it occur.
How does it work?
A firm of UK exporters is to receive a payment of USD 10,000,000 in a year’s time. They want to protect the GBP value of the payment so that the conversion rate will be no higher than 1.3000. Therefore, they purchase a USD put/GBP call option with a strike price of 1.3000.
In a year’s time, if the GBP/USD rate is above 1.3000, i.e. if the option is ‘in the money’, they can exercise the option and still exchange at 1.3000. If the rate is below 1.3000, and the option is ‘out of the money’, they can enter the market at the advantageous spot rate, letting the option expire worthless.
- Provides the holder with a pre-agreed worst-case exchange rate
- Provides the holder with the flexibility to benefit from a lower exchange rate, should the spot rate be lower than the option strike at expiry
- Requires only a minimal two-day credit line between purchase of, and payment for, the option
- The holder has no obligation
- The holder will incur a premium cost, usually paid up front
- If the option expires ‘out of the money’, no value will be received. The option will expire worthless, similar to an insurance contract
FX Option scenarios: