FX options are effectively an insurance policy that can be a great way to hedge an investor's spot in currency market. Currency market fluctuations can have a lasting impact on cash flow whether it is buying a property, paying salaries, making an investment or settling invoices. By utilizing FX options, businesses can protect themselves against adverse movements in exchange rates.
How does an FX option work?
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. It provides protection against an adverse movement in the chosen currency at the agreed-upon strike rate.
There are two types of options; A call option that gives the option to buy at a certain price and a put option, which gives the option to sell at a certain price. An option buyer (call option) would like the price of the asset (FX rate) to go up so that the trader can exercise his option to buy at a lower price at the moment and vice versa- the option seller (put option) would like the price of the asset (FX rate) to go down.
Example of FX Options Trading
Let's say an American importer of European products is worried that the euro will strengthen against the U.S. dollar. The importer purchases a currency call option on the euro with a strike price of 1.15 with a notional amount of 10,000 euros. When the investor purchases the option, the spot rate of the euro is equivalent to 1.10.
Assume the euro's spot price at the expiration date is 1.18 Consequently, the currency option is said to have expired in the money. Therefore, the investor's profit is $30,000, or (10,000 * ($118 - $115)), less the premium paid for the currency call option.
It is important to note that the intrinsic value of a bought FX option cannot be negative. The purchaser, or holder, of the FX option, has all of the rights and would not choose to exercise the FX option if the market rate was above the strike price. They would simply choose to walk away from the FX option, let it expire worthlessly, and transact at the higher market rate.
The Benefits of FX Options
It allows you to budget and plan your cash flows with certainty-
-It gives you opportunity to benefit from favorable foreign exchange movements
-It protects you against the direct impact of unfavorable changes in foreign currency values
-It allows you to manage your foreign exchange risk and provides flexibility if your business circumstances change
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