What are currency options?
More currency options
There are numerous types of currency options available to exporters to use including knock-ins, knock-outs, barrier options, digital options, exotic and straddle options to name a few.
When dealing with currency options, exporters may hear terminology such as strike price, expiry date, volatility, delta, time decay, gamma and others. Exporters do need to have an understanding of this terminology and the options’ various components.
Many currency option products will be unsuitable for export businesses. The key component for any export business is, before entering into an option strategy, be sure that the stakeholders fully understand the option product, the currency risk the option is being used as a hedge against, the worst-case scenario the exporter should face if unfavourable price action unfolds, and if the hedging option is suitable to the exporters’ currency exposure.
Risk management
Any exporter using currency options to hedge their currency exposure need to consider whether the products fall within the guidelines of the exporters’ risk management policy. Monitoring the value of option structures is complex, and many exporters will not have the software nor the systems to be able to calculate net present value or be able to ‘mark to market’ their options structure independently. If entering into a complex structure, remember: the more complexity within an options structure, the more expensive it will become.
It is crucial that any exporter seeking to enter into an options hedge has a full understanding of what exactly it is they are buying into. Do not enter into an option structure that has the capacity to create losses. Option structures should be designed to reduce currency risk, not increase it. Many option structures have knock-in/knock-out clauses that sees the option expire if a currency trades to a certain level, sometimes leaving the buyer unhedged at levels far from market.
Using options
Currency options are flexible products that differ from forward exchange contracts in that the buyer of the option is not obliged to exercise the option. This flexibility is attractive to exporters who experience delays in their supply chain. For an upfront premium, exporters can take a currency option that is tailored to their specific currency exposure. Currency options can also be zero cost, which allows exporters to take protection against currency movements without any impact to cash flow or operating costs.
However, unlike other hedging tools, currency options are a complex product by comparison. It is difficult to calculate net present value or revalue currency options on a mark-to-market basis like forward exchange contracts. Currency option structures can also be complex in their structure, and it can be both difficult and time-consuming for exporters to fully understand the product they are dealing with. Unlike other financial instruments, options are not transparent their pricing, making it difficult for the buyer to know what fair value is for the cost of the option they purchase.
—Jason McClintock was the senior manager at American Express FX International Payments
Glossary
delta: A measure of the rate of change of an option value with regard to changes in the underlying asset’s price.
gamma: A measure of the rate of change in the delta with respect to changes in the underlying price.
mark-to-market: Assigning a value to an asset equal to the current market price of the asset
strike price: The price at which the asset will be bought or sold when the option is exercised.
time decay: The process by which an option’s value drops as it nears its expiry date.
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