What is Currency Options?
Currency options are financial derivatives that give the holder the right, but not the obligation, to exchange one currency for another at a pre-determined exchange rate (known as the strike or exercise price) on or before a specified expiration date. These options are used in the foreign exchange (Forex or FX) market to hedge against currency fluctuations or to speculate on future currency movements.
Currency options are another set of derivative products that can be used for hedging foreign exchange risks. These options can be exchange traded or OTC traded. OTC options are structured for corporates by commercial banks and investment banks. In India, currency options are available in National Stock Exchange (NSE)’s derivative exchange.
A currency option is a contract where the buyer of the option has a right but not obligation to buy (or sell) an agreed amount of foreign currency against another currency at an exchange rate fixed during the purchase, applicable for a specified period or on a specified future date.
The buyer pays a fee called the option premium to the seller (also called writer). If the option gives the right to buy a foreign currency, it is termed call option, while an option that gives the right to sell a foreign currency is called a put option. The writer of the option has an obligation to buy/ sell the currency, and hence, while the risk to a buyer of an option is limited to the option premium, the risk to the writer is unlimited. In the case of currency options, since the underlying commodity of the derivative contract is a currency, a call option on a foreign currency is same as the put option on home currency.
Options can be used by corporates for hedging exchange rate risks. Since the option gives the right to buy/sell a foreign currency at a pre-fixed price (called strike price or exercise price), it is similar to a forward contract, which also enables pre-fixing forward exchange rate except that the forward contract has an obligation to buy/sell at the contracted rate irrespective of the currency movement (whether adverse or favourable), while option buyer has no obligation. Consider an exporter who has $10 million to be received after six months.
The current spot rate is USD/INR 65 and the forward rate is USD/INR 66. If the exporter enters into a forward contract to sell $10 million at USD/INR 66 after six months and if the exchange rate happens to be USD/INR 70, the exporter is obliged to sell the export proceeds at the contracted rate of 66, even though he could have earned more at the spot rate of 70 if he had not hedged it with forward contract. On the other hand, if the spot exchange rate turns out to be 60, the forward contract would have protected him from the lower exchange rate.
Thus, the forward contract removes the downside risk but does not allow the exporter to partake of profits from any favourable movement in exchange rates. In comparison, the currency option buyer does not have any obligation. He has the option of exercising his right to buy the currency or let the contract expire without taking any action. If he lets the contract expire, his loss is only the option premium paid initially.
For example, if the exporter above has purchased a USD-INR six-month currency put option at a strike price of 66, instead of entering into a forward contract, and if the exchange rate on the future date is 70, since the exchange rate in the spot market is more favourable than the option strike price contracted, he can realise his export proceeds through the spot exchange market and leave the option contract to expire without exercising his right to buy the contracted USD amount.
As long as the option premium paid by the exporter is less than INR 4/USD, he will make profit by ignoring the option contract and transacting in the spot market. Options can be of two types: European and American. The European type of option contracts allow exercising of option contracts only on the maturity date of the contract. The American options, on the other hand, allow exercising at any time during the contract period until the maturity date.
The settlement of options is not done by the delivery of the contracted currency amount. Instead, a settlement of the price difference between the contracted rate and the rate prevailing on the maturity date (settlement rate) is done. In the case of exchange-traded options, parties to the contract will be required to maintain a margin account with the exchange, which will be marked to market on a daily basis. In India, currency options were introduced in the NSE derivative exchange in October 2010. At present, only currency options on USD are available.
Table gives sample prices prevailing at NSE as on 26th November 2015 for contracts maturing on 29th December 2015:
Option contracts traded in the NSE are for the delivery of $1000 each. The option premium or prices quoted above are in terms of rupees per $. Suppose an importer needs to purchase $10 million and decides to hedge it with call option contracts maturing on 29th December 2015 at a strike price of 66. For $10 million, he has to purchase 10000 contracts and would have to pay a premium of INR 92,25,000 if executed at the last traded price of INR 0.9225/$ per $1000 contract.
Hedging With Currency Options
Currency options can be used for hedging foreign exchange exposures similar to forward contracts. However, there are some major differences with regard to hedging with currency options as compared to hedging with forward contracts:
- Hedging with currency options require the payment of initial option premium fees. In comparison, forward contracts are free and do not involve any cost associated with them.
- Hedging with forward contracts involves a legal obligation to buy/ sell currency on the maturity date. However, currency options give the right to buy/sell, but there is no obligation on the part of the option buyer.
- The concept of right but not obligation makes option contracts more useful in hedging the exchange rate volatility as the buyer can take the advantage of favourable movements by allowing options to expire.
- Currency options are generally exchange-traded derivative contracts as compared to the OTC nature of forward contracts. They also involve the maintenance of margin with the exchange and daily cash inflows/outflows.
- Currency options can be used for anticipated or contingent forex exposures. For example, an import payable is a certain exposure. However, a tender contract quoted in a foreign currency that involves future expenditure in foreign currency if and when the contract is awarded is a contingent exposure. Such exposures can be hedged only with currency options as it is possible to allow the contract to expire if the tender is not awarded.
Illustration: A firm needs to make a loan repayment of $1 million due in December, 2015. The current spot rate is 66.5. The firm decides to hedge this payable with option contracts and would like the exchange rate on the date of purchase to be 66.5. What is the option premium payable as per NSE prices given in Table 10.3? If the exchange rate on the maturity date is a) 64.5 or b) 67.5, what is the effective exchange rate at which the firm will purchase the dollars?
Solution: The firm would have to purchase 1000 call option contracts at a strike price of 66.5 at an option premium of 0.5975 (assuming executed at the last traded price).
Option Premium payable = No. of contracts × $1000 × Option premium
= 1000 × 1000 × 0.5975
= INR 5, 97, 500
Case (a): Exchange rate 64.5
On the maturity date, if the exchange rate is 64.5, the firm will not exercise the option. It will purchase dollars in the spot market at 64.5.
The total cost involved (Ignoring opportunity cost of the premium paid) = 64.5 × 1000,000 + 597,500 = INR 6, 50, 97, 500
The effective exchange rate = 6, 50, 97, 500/1000000 = 65.0975.
Case (b): Exchange rate 67.5
Since the exchange rate is higher than the strike rate, the firm will exercise the option at 66.5.
The effective exchange rate will be the strike rate plus the option premium, i.e. 66.5 + 0.5975 = 67.0975.
The total cost involved (ignoring opportunity cost of the premium paid) = 66.5 × 1000,000 + 597,500 = INR 6, 70, 97, 500
The effective exchange rate = 6, 70, 97, 500 / 10, 00, 000 = 67.0975