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What are currency options?

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Often regarded as the most difficult to understand aspect of foreign exchange, options can be great tools to have in your business' currency management kit once you understand what they can do. The global financial crisis and resulting recession across Europe and the USA has caused extreme volatility in currency markets over the last 18 months. Australian exporters who earn revenue in foreign currency have been severely impacted by wild fluctuations in these currency markets. Increasingly, Australian exporters are turning to currency options to hedge their currency exposures, but like all hedging tools, these products have their strengths and weaknesses. A currency option gives the buyer of the option the right, but not the obligation, to buy or sell a currency at an agreed rate for a future date. Currency options can be simple vanilla types such as a 'call option' or a 'put option'. However, there are many types of options available and complex financial engineering strategies can be devised using a combination of different option products. A key point to remember for exporters is that the more complex an option structure becomes, the more expensive it becomes. Also with increased complexity, the harder it is for exporters to understand their risk exposures and calculate the value of the option structure. Many exporters will not have adequate systems in place to calculate either.

Call option

This is an option where the buyer has the right, but not the obligation, to buy a currency at a set rate on a future date. Exporters, for example, could use an AUD/USD call option to protect their profit margins by buying the right to buy AUD/USD on a future date. Example: An exporter has contracts where they expect to receive US$1 million by April 30, 2010. Buying an option is a good idea if the current spot AUD/USD rate is 92 cents and the exporter is concerned the AUD/USD may rise before April 30 and wishes to protect the profit margins. The exporter may then buy a 95-cent call option for expiry on April 30, 2010. If the spot AUD/USD is above 95 cents at expiry, the exporter will exercise his right to buy AUD/USD at 95 cents. If the spot rate is lower than 95 cents, the exporter will allow the option to expire, and buy the AUD/USD at the prevailing spot AUD/USD rate. Strengths: Profit margins protected at 95 cents, with unlimited downside potential if the AUD/USD rate should experience sustained weakness by maturity. Weakness: Exporters will be charged a premium to buy the option, which is non-refundable, affects cash flow and adds to operating costs.

Put option

This is an option where the buyer has the right, but not the obligation, to sell a currency at a set rate on a future date. Importers, for example, could use an AUD/USD put option to protect their profit margins by buying the right to sell AUD/USD in the future.

Zero cost option

This option is a structure that is a combination of both a call and a put option, also known as a collar option. An exporter using this method would buy a call option, and at the same time sell a put option. The cost of the call option, which protects the exporter from a rising AUD/USD, is offset by the premium earnt from selling the put option. Example: If a spot AUD/USD rate was 92 cents, the exporter may buy a 95-cent call option, while selling a 90-cent put option. At maturity, if the AUD/USD is above 95 cents, the exporter exercises the right to buy at the lower rate of 95 cents. If the AUD/USD is below 90 cents, the buyer of the put option will exercise their right to sell the AUD/USD. If the AUD/USD is in between 90 cents and 95 cents, the exporter allows the options to expire, and simply does a spot transaction at the prevailing rate. Strengths: Zero cost means the strategy can be put in place with no upfront premium. The exporter has complete protection both sides of the market and can work out profit margins, revenue generation and budget projections. Weakness: Should the AUD/USD rate weaken sharply, the exporter is unable to take advantage of that as the purchaser of the 90-cent put option will exercise their option to sell AUD/USD at 90 cents should AUD/USD be lower at expiry.

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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