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 (strike rate) on or before a pre-agreed date.
The purpose of an FX Option, which can be a Call or Put, is to establish an exchange rate on a future transaction to hedge against adverse currency moves.
How does it work?
A firm of UK exporters expects to receive a payment of $10 million in a year’s time. They want to protect the value of the payment in sterling so that the conversion rate will be no higher than £1.00 = $1.30 and so purchase a dollar Put/sterling Call option with a strike price of $1.30.
In a year’s time, if the exchange rate is above $1.30, the option is ‘in the money’ and the UK firm can exercise the option. If the rate is falls below $1.30, and the option is ‘out of the money’, the business can let the option expire and exchange dollars into sterling at the market rate.
- The Holder has the certainty of a pre-agreed exchange rate
- The Holder has the flexibility to benefit from a lower exchange rate
- The Holder has no obligation
- The Holder will incur a premium cost, usually paid up front
- If the option expires ‘out of the money’, the Holder will receive no value
FX Option scenarios: