Currency Options What are the Currency Options? Currency Options are Derivative contracts that enable market participants which includes both Buyers and sellers of these Options to buy and sell the currency pair at a pre-specified price also known as Strike Price on or before the date of expiry of such derivative contracts.
These are Non-Linear instruments and are used by Market participants for both Hedging and Speculation purposes. Types of Currency Options 1 — Currency Call Options to buy dollars options are entered into with the intent to benefit from the increase in the price of the currency pair.
What are the Currency Options?
It enables the buyer of the option to exercise his right to buy the currency pair at the pre-specified strike price on or before the expiry date of the contract. If on expiry, the currency pair is below the Strike Pricethe option ends worthless, and the Option seller pockets the premium received. It enables the buyer of the option to exercise his right to sell the currency pair options to buy dollars the pre-specified strike price on or before the expiry date of the contract. If on expiry, the currency pair is above earn 2020 fast Strike Price, the option ends worthless, and the Option seller pockets the premium received.
The company wishes to protect itself against any adverse movement in the currency rate.
To protect itself from any adverse moment which can arise on account of appreciation of local currency INR against the US Dollar, the company decided to purchase Currency Options.
By entering into an option with strike price 73 and expiry of three months, Larsen has covered its risk of fall in the price of foreign currency against the local currency Indian Rupee.
Now, if the overseas currency US Dollar strengthens in the interim period, the company will benefit from stronger currency when translating its profits in Indian Rupee and will suffer the loss of the premium paid to purchase the option.
However, on the contrary, if the foreign currency got weaker compared to the local currency INR which means INR getting stronger against US Dollarthe currency option purchased by Larsen will ensure that it can translate its profit in India Rupee at the pre-specified rate, i. Avon Inc specializes in Hedge trades of such options. Derivation of rates is mentioned below — Advantages It allows traders to take leverage trades as the premium cost of the option contract is very minimal compared to the actual buying of the contract, which enables them to take a large position by paying a nominal premium.
For this right, a premium is paid to the seller.
It is a low-cost tool for hedging and can be used by Corporate to hedge against any adverse currency movement. Disadvantages Due to the high leveraged position, Currency Options are prone to manipulation by speculators and cartels.
Foreign Currency Futures
Also, currency markets are controlled by the local government of each country, which impacts the Value of Currency Options. Important Points This option comprises of two values that together determine the cost of the option, namely; Intrinsic Value and Extrinsic Value Intrinsic value refers to the value by which the option is in the money.
In this case, the intrinsic value of this option is Rs 1, which is the amount by which the option is in the money. Extrinsic value is the value attributed to time and volatility associated with the currency pair. The more the time to expiry and the higher the volatility, the greater will be the extrinsic value of an option.
Conclusion This is an effective way to make the most out of Currency pairs and are used effectively by Traders, Speculators, and Corporate, etc. Here we discuss the types along with the practical example, advantages, and disadvantages. You can learn more about excel modeling from the following articles —.