Currency Options Overview

A currency option is the right - but not the obligation - to buy (in the case of a call) or sell (in the case of a put) a set amount of one currency for another at a predetermined price at a predetermined time in the future. The two parties to a currency option contract are the option buyer and the option seller/writer. The option buyer may, for an agreed upon price called the premium, purchase from the option writer a commitment that the option writer will sell (or purchase) a specified amount of a foreign currency upon demand. The option extends only until the expiration date.

The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price or strike price. The total description of a currency option includes the underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put.

There are two types of option expirations - American-style and European-style. American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration only. Currency options may be quoted in one of two ways: American-terms, in which a currency is quoted in terms of the U.S. dollar per unit of foreign currency; and European-terms (inverse terms), in which the dollar is quoted in terms of units of foreign currency per dollar.

The same logic can be applied to currency pairs in which the U.S. dollar is not one of the currencies. Either currency can be expressed in terms of the other. It's really no different to options on shares, real estate or whatever. The basic premise is that the buyer of an option has the right but not the obligation to enter into a contract with the seller. Naturally the option owner exercises this right when it is to his/her advantage.

Currency options specify a foreign exchange contract and give the owner the right to enter into the specified contract during a pre-agreed period of time. Currency Options have gained acceptance as invaluable tools in managing foreign exchange risk. They are used extensively and make up between 5 - 10 % of total turnover.

Currency options bring a much wider range of hedging alternatives to portfolio managers and corporate treasuries. This area of Washington Prime Plus inc. is devoted to furthering the understanding of what currency options are, how they are priced and how they can be used. In the near future we will be bringing options pricing tools onto the site and also a section that simplifies the mathematics behind options pricing. Options in General: Definition and Use Options are actively used within many companies as a risk management tool and are an important tool in that process.

As managers of risk it is important to have a good understanding of options as it applies well to our unique position in the market place. What is an option? Simply stated, an option is a choice. The buyer of an option acquires the right and not the obligation, to buy or sell an underlying asset under specific conditions in exchange for the payment of a premium. It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to perform. A call option conveys the right to buy the underlying asset, and a put option gives the buyer the right to sell.