Types of Options
There are two basic types of options: Put Option and Call Option
This option gives the buyer the right to purchase or “call away” a specified amount of the underlying foreign currency at a specified price up to a specified date. The price at which the foreign currency may be bought is the exercise price. The last date on which the option may be exercised is the expiration date or the maturity date. The price of the option is its premium.
This option gives the buyer the right to sell or “put to” the issuer (writer) of the option a given amount of foreign currency at a given price up to a specified expiry date.
Exporters will normally require “put options” and importers will normally require “call options”.
Forms of foreign currency options
Foreign currency options are available in two major forms:
- Over-the-counter (OTC) Options: i.e. an option written usually by an international bank to meet the particular requirements of a customer. It is tailor-made or customized, that is, the amounts and the expiration dates are mutually agreed upon between the bank and the customer.
- Exchange traded options i.e. standardized (as to amounts and maturity dates) contracts, traded on a number of exchanges such as the Philadelphia stock exchange, Chicago mercantile exchange, Chicago options exchange. Exchange traded options cannot be tailor made to meet specific customer needs. There are four settlement dates each year specified by the particular exchange.
A further sub-division is that of:
- American option is one that can be exercised at any time until maturity. It conveys more rights and hence must be worth more.
- European option is the one that can only be exercised at maturity.
- Asian option is an average rate option; the difference between the strike rate and the average exchange rate over the option’s life. Premium under Asian option is normally less than for European or an American option.
The other terms associated with options are:
The party which obtains the rights by paying a premium, that is conferred by an option; the right- but not an obligation – to buy the foreign currency if the option is a call or to sell the foreign currency if the option is a put. The option buyer is also known as the holder.
The party who is obligated to perform if an option is exercised; to sell the foreign currency at a stated price if a call is exercised or to buy the foreign currency at a stated price if a put is exercised. The option seller is also known as the option writer or issuer.
For foreign currency option traded on the exchanges are March, June, September and December. At any given time, trading is conducted in the nearest three months.
The last date on which an option may be exercised is usually, the Saturday before the third Wednesday of the expiration month.
The price of an option- this is the “upfront” payment made by the purchaser to the writer and it is usually paid at the time the option contract is granted.
Notice of exercise:
Only an option-holder may exercise an option by assigning a notice of exercise to an option writer at any time prior to expiration of the option.
The price of an option consists of two elements, intrinsic value and time value.
An alternative to exercising the option is to sell it back to the bank at its intrinsic value (if any). The intrinsic value is the difference between the strike price and current spot rate of the underlying currency. An option is said to process intrinsic value if option would currently be profitable (over and above the premium paid). In the case of a call option, the price of the underlying foreign currency is above the option exercise price.in the case of a put option, the spot price is below the option exercise price. Such an option is said to be in-the-money. For example, if the spot DM price is $ 0.043, a DM 40 (i.e. DM1=$0.40) call option would have intrinsic of $ 0.003 per DM while a DM40 put option would have no intrinsic value.
It is the difference between the premium on the option and its intrinsic value. This is the seller’s compensation for the possibility that the option will be worth more at the end of its life than if the option is exercised immediately.
At- the-money option:
An option whose exercise price is the same or very nearly the same as the spot price.
Out- of-the-money option:
A call option whose exercise price is above the current spot price of the underlying currency or a put option whose exercise price is below the current spot price of the underlying currency. Such options have no intrinsic value.
A call option whose exercise price is below the spot price of the underlying currency or a put option whose exercise price is above the current spot price of the underlying currency are money option with an intrinsic value.
It is the one under which the premium is returned if the option is not exercised. The premium is set at a high enough level that the interested earned on it is sufficient to pay the true option cost.
This is the most common option used by corporations bidding for contracts overseas.
It gives the buyer the right to “look back” over the period of option and deal at the best possible rate during the period. The premium in such option is considerably high.
It expires prematurely if the exchange rate falls below a certain level.
It expires prematurely if rates ever exceed a specified level.
Inside trading range option:
It expires prematurely if rates ever move outside a specified range.
Outside trade range option:
It expires valueless unless rates have been on both sides of a specified range.
To summarize, the three main methods for protection against the risk of exchange rate fluctuations are forwards, futures and options.
The customer benefits of traded options:
- The purchaser can choose the strike price.one of the factors which influences the option premium is how far the strike price differs from the relevant forward rate.
- The currency option provides for more flexibility then forward contract or other methods of covering exchange risk.
- The purchaser can take advantage if spot rates move in his favor, by simply abandoning the option.
- If the underlying commercial deal falls through, the purchaser will be able to sell the option back to the bank, provided the option has an intrinsic value.
Customer benefits of OTC option:
As opposed to exchange traded option
- OTC options are tailor made, whereas exchange traded options are standardized and may not match the customer’s requirements.
- OTC options involves less administration on the part of the purchaser. With exchange traded options it is necessary to deal via authorized brokers.