Currency Options Definitions and Use

Currency Options: Definitions, Risks, Usage and Prices

Many corporations, portfolio managers and forex traders use currency options actively as a risk management and/or risk-taking tool. Anyone using or contemplating using forex options would benefit from developing a solid understanding of what options are, how they are priced, how they are quoted, and what position they occupy in the marketplace.

In essence, a currency option contract confers a choice upon its buyer who acquires the right, but not the obligation, to buy or sell one currency against another under specific conditions that include price and time period, all in exchange for the payment of an upfront premium. It remains the forex option buyer’s choice whether or not to exercise the right they have purchased, and only the seller of the option is obligated to perform. Of course, the forex option buyer will only exercise their right when it is to their advantage to do so relative to the prevailing market price for the underlying currency pair.

Typically, a “call” option conveys the right to buy the underlying asset, while a “put” option gives the buyer the right to sell; however, in every foreign exchange transaction, one currency is purchased and another currency is sold. Consequently, every currency option is both a call and a put since the underlying contract is an exchange of one currency for another. 

For example, an option to buy Australian Dollars against the U.S. Dollar is both an Australian Dollar call and a U.S. Dollar put. Conversely, an option to sell Australian Dollars against U.S. Dollars is an Australian Dollar put and a U.S. Dollar call. As a result, to avoid confusion when trading a currency option, you need to be explicit about exactly which is the call currency and which is the put currency.

Common Currency Option Definitions

Some of the more commonly-used terms you might come across while trading in the currency option market are defined below:

Buyer: The purchaser of an option; also referred to as the option holder.

Seller: The counterparty who sells an option; also referred to as the writer or grantor of the option.

Call: An option which gives the option buyer the right to purchase or “go long” a particular currency against another.

Put: An option which gives the option buyer the right to sell or “go short” a currency, but obligates its seller to buy the currency, if assigned.

Underlying: The exchange rate of the currency pair in which the option buyer has obtained the right to purchase or call one currency and sell or put the other currency.

Strike Price: The exchange rate at which the buyer of has the right to purchase or call one currency and sell or put the other currency, also referred to as the exercise price. The strike price is determined at the time the option contract is purchased.

Premium: The amount of money that the option seller receives and the option buyer pays for the rights conveyed by the option. The premium represents the maximum amount the option buyer can lose on their option trade.  It also reflects the insurance fee that a hedger might pay to protect against a particular exchange rate risk using a currency option.

Price: The cost, usually expressed in percent or pips, of the currency option that is multiplied by the appropriate face amount of the currency option purchased to obtain the premium amount.

Exercise: The action taken by the buyer (holder) of an option who wishes to make the underlying currency exchange at the option strike price. If the buyer exercises their option, they will acquire a long position in the call currency in exchange for a short position in the put currency. At the same time, the seller of that option will be obligated to take a short position in the call currency and a long position in the put currency.

Assignment: Occurs when the buyer of the option contacts the seller to exercise their option. When this happens, the seller would be “assigned” by the buyer, and becomes obligated to perform on their side of the currency option contract at the strike price.

Expiration Date: The last day on which an option can be exercised. Options expire on a specific date that is agreed between both counterparties at the time the option is initially transacted.

Delivery Date: The day, usually spot or two business days after the exercise date, upon which the underlying foreign exchange contract is agreed to be settled or delivered between the counterparties to the currency option.

European-Style: Refers to a class of options that can only be exercised on their expiration date.

American-Style: Refers to a class of options that can be exercised on any business day after their initiation, up to and including their expiration date.

Intrinsic Value: The amount of money, if any, that could currently be realised by exercising a currency option with a given strike price, relative to the prevailing forward exchange rate for the option’s delivery date. A call option on the primary currency (put on the secondary currency) has intrinsic value if its strike price is below the forward exchange rate. A put option on the primary currency (call on the secondary currency) has an intrinsic value if its strike price is above the forward exchange rate.

In-The-Money: This term is applied to an option that has intrinsic value and is commonly abbreviated as ITM.

Out-Of-The-Money: Applies to an option that has no intrinsic value. A call option is said to be "out-of-the-money" or OTM if the underlying spot exchange rate is currently less than the strike price of the option. A put option is said to be "out-of-the-money" if the underlying spot exchange rate is currently more than the strike price of the option. An option that is "out-of-the-money" on its expiration date will have no value, and the holder of the option will allow it to expire worthless.

At-The-Money: Means that the strike price and the exchange rate are the same. In the foreign exchange market, this designation can be used with either the spot or the forward rate pertaining to the currency pair involved, so the terms at-the-money-forward (ATMF) and at-the-money-spot (ATMS) are frequently used. As with an "out-of-the-money" option, the holder of an “at-the-money” or ATM option at expiration would allow the option to expire worthless.

Currency Option Risk Profiles and Expiration Value

Determining what a currency option is worth on its expiration date is easy. Its value at expiration will reflect the sum that could be realised by the holder of the option by exercising that option and closing out the resulting foreign exchange position at the prevailing market. If that sum is zero or negative, then the option is worthless and will be left to expire without being exercised by its buyer.

Table 1 below shows from a trading perspective what each of the possible option trade types will do to your overall risk profile or position.

Table 1:  Trade Type Risk Profiles.

RISK

Forwards

Calls

Puts

 

ATTITUDE

RISK

ATTITUDE

RISK

ATTITUDE

RISK

BOUGHT

BULLISH

HIGH

BULLISH

LOW

BEARISH

LOW

SOLD

BEARISH

HIGH

BEARISH

HIGH

BULLISH

HIGH

By reviewing Table 2, you can get a sense of the limitations in terms of trading profit and loss that bought and sold options confer to your risk profile.

Table 2: Option Trade Risk Limitations.

LIMITATIONS

BOUGHT

SOLD

PROFIT

UNLIMITED

LIMITED

LOSS

LIMITED

UNLIMITED

Table 3 below illustrates the relative “moneyness” of calls and puts on the major currency depending on where the spot rate is relative to the option’s strike price at expiration.

Table 3: Currency Option Moneyness.

OPTION TYPE

Spot exchange rate is greater than strike price

Spot exchange rate is equal than strike price

Spot exchange rate is less than strike price

CALLS

In-The-Money

At-The-Money

Out-Of-The-Money

PUTS

Out-Of-The-Money

At-The-Money

In-The-Money

Currency Option Hedging Applications

Foreign exchange options are commonly used by corporate treasuries to protect or “hedge” against currency fluctuations where some degree of uncertainty exists in the risk to be hedged.

Australian Importer Case Study

For example, consider the case where an Australian-based importer has the obligation in three months time to pay USD$1,000,000 for a commodity such as soybean meal. The importer has several alternatives which include:

a) Remain unhedged and purchase the U.S. Dollars when needed at the spot rate prevailing in three months’ time.

b) Hedging by buying U.S. dollars and selling Australian Dollars forward using a forward foreign exchange contract, and

c) Hedging by using an option strategy like buying a three month Australian Dollar put/U.S. Dollar call option. The effect of buying an Australian Dollar put/U.S. Dollar call is to place a ceiling on the cost of imports without limiting the potential benefit to the company if the Australian Dollar rises with respect to the U.S. Dollar over the three month lifetime of the exposure. By using this hedge, the importer places a limit on their costs while being able to participate in unlimited possible gains.

Australian Exporter Case Study

In the case of an Australian-based exporter who will be receiving USD$1,000,000 in three months’ time as payment for a commodity, their hedging alternatives include:

a) Remain unhedged and sell U.S. Dollars/buy Australian Dollars at the prevailing spot rate in three months’ time.

b) Hedge by selling U.S. dollars/buying Australian Dollars forward;

c) Hedge by using an option strategy such as buying a three month Australian Dollar call/U.S. dollar put option. The effect of buying a Australian Dollar call/U.S. Dollar put is to guarantee a minimum value for the exporter’s U.S. Dollar receivables in their local currency, while not limiting their potential gains should the Australian Dollar fall against the U.S. Dollar over the coming three months.

Transacting Currency Options

Quotation Basics

First a quick review. You will recall that 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 against another upon demand. The option extends only until the expiration date. The exchange rate at which one currency can be purchased or sold against the other is one of the terms of the option and is called the exercise price or strike price.

When contemplating a currency option transaction, you will need to be very clear with your counterparty about accurately describing the exact contract you are interested in. This description includes:

  • The pair of underlying currencies,
  • The contract size and quantity, or the face amount,
  • The expiration date,
  • The strike price and whether it is to be expressed in European or American terms.
  • Whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put.
  • The option style - American-style or European-style.
  • The quotation style you prefer for premium calculations - percent or points of which face amount.

Like exchange rates themselves, the strike prices of currency options are typically quoted in one of two ways:

  1. American terms: in which a currency is quoted in terms of the U.S. dollar per unit of foreign currency, or
  2. European terms: in which the U.S. dollar is quoted in terms of units of foreign currency per U.S. dollar.

Similar terminology 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.

Components of an Option’s Price

The price or premium quoted for a particular option at a particular time represents the market’s consensus of the option's current value. This value is comprised of two basic elements: intrinsic value and time value.

Intrinsic value is simply the difference between the forward foreign exchange rate at the delivery date and the strike price.  For example, a European-style Australian Dollar put/U.S. Dollar call option will only have intrinsic value when the forward price is below the strike price. Conversely, a European-style Australian Dollar call/U.S. Dollar put option will only have intrinsic value when the forward price is above the strike price. You will recall from the definitions section above that options which have intrinsic value are said to be "in-the-money."

Time value is more complex to calculate. When the price of a call or put option is greater than its intrinsic value, it is because it has time value. Time value is determined by five variables: the spot or underlying price, the expected or in practice the “implied” volatility of the underlying currency pair, the strike price, time to expiration, and the difference in the "risk-free" rate of interest that can be earned by the two currencies, usually the prevailing interbank deposit rates. Time value falls toward zero as the expiration date approaches. You will recall that an option is said to be "out-of-the-money" if its price is comprised only of time value.

Currency Option Pricing Models

A variety of fairly complex option pricing models, such as the Black-Scholes and Cox-Rubinstein models, have been developed to determine option pricing for stock options. Nevertheless, the most commonly-used model for currency option valuation is the Garmen-Kohlhagen model that is based on the Black-Scholes model, but which properly accounts for continuous returns in both currencies.

Many texts are available which cover the specifics of option pricing models in detail if you are interested in delving deeper into the calculations themselves. Interest rate differentials between nations and temporary supply/demand imbalances during trends, for example, can also have an effect on option premiums.

In the final analysis, as in any market, option prices must be low enough to induce potential buyers to buy and high enough to induce potential option writers to sell.

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