FX option
Summary
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.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.
Objective
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 an FX option 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 purchases 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 U.K. firm can exercise the option. If the rate 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.
Two scenarios of where the exchange rate could settle and what the holder of the FX option will need to pay.
Advantages
- 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
Disadvantages
- 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
An example of what an FX option trade could look like.
An illustration of the outcome of an FX option relative to the exchange rate.
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Disclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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