We have examined the two main methods of covering an exchange rate fluctuations risk i.e.

  1. The traditional forward exchange contract, and
  2. The currency futures contract.

An option is an agreement between two parties. One party grants the other the right to buy or sell an instrument under certain conditions. The instruments may be a stock, bond, futures contract, interest rate or foreign currency. Unlike forward contract and futures contract, which must be exercised, the currency options give the buyer the right (opportunity) but not the obligations to buy or sell at a pre-agreed price, the strike price or exercise price. Both the forward contract and currency futures are built around a forward commitment to exchange currencies at some future date. For hedging certain contingent exposures, such as when tendering for a contract or when publishing price-lists, the forward exchange contract or the currency futures contract was found unsuitable. Non-acceptance of the tender or non-materialization of an order would result in the need to cancel the forward or futures contract by an offsetting deal at, maybe, unfavorable exchange rates entailing loss to the trader. Accordingly, along the lines of stock options prevalent since 1973, the Philadelphia stock exchange in 1982 created the world’s first widely traded currency option.

In a currency option the counter party pays a premium for the privilege of being able to buy or sell without committing to do so.in other words the buyer pays a premium irrespective of whether the buyer exercises the option or not. An option is a one-way bet

The period during which the option can be exercised depends on its type.

American or European:

Under an American option, the holder of the option has the right to exercise at any time before maturity. Under the European option, the holder may only exercise it at the time of expiration or for a short period before-hand.

Advantages  

The main advantage to the buyer of a foreign currency option are:

  1. The loss is limited to the amount of premium paid to the seller, at the time the contract is entered into, and no further expense is involved.
  2. The profit on the tender or offer is assured as on the date of the exposure and the potential for further gains is retained, should the exchange rates move in favor of the buyer.
  3. Since such a contract does not involve any obligation to exercise the option, it is the best method of covering a contingent exposure.
  4. No credit line is needed as in the case of forward exchange contracts; nor is margin required as in the case of futures contract.
  5. Options contracts offer a range of strike prices and are, therefore, more flexible than forward and future contracts.

Disadvantages

The main disadvantages are:

  1. Being more flexible, they are more expensive than forwards and futures.
  2. In a currency option only a limited range of currencies are available.
  3. While over-the-counter options contracts. Offered by banks are tailor-made to the requirements of customers, only standard expiration dates and strike prices are available on the trading markets.
Foreign Currency OptionsCapital Budgeting TechniquesWe have examined the two main methods of covering an exchange rate fluctuations risk i.e. The traditional forward exchange contract, andThe currency futures contract. An option is an agreement between two parties. One party grants the other the right to buy or sell an instrument under certain conditions. The instruments may be a...Investment analysis basics