Explanation of a Foreign Exchange Option

A foreign exchange option is a contract that provides a purchaser the right, but not the obligation, to buy or sell a given amount of a foreign currency at a set price at a set date in the future. Foreign exchange options can be used to generate profit for private investors, but they are more often used by importers looking to ensure the price of their goods will not rise sharply due to an unfavorable exchange rate.

Example

For example, imagine an olive importer has an order for 1,000 olive trees that will cost $1,500USD to import from Europe. The current exchange rate is 1:1, and the importer collects payment from the vendor accordingly. However, a week from today, the exchange rate tips, and $1USD is equal to only .98 euro. As a result, the importer will lose profit. Thankfully, the importer purchased an option to buy 1,000euro for $1,000USD that matures at the time the trade will take place. The importer exercises the option and secures the 1,000euro for a price of $1,000USD, and his profit remains the same. Speculators use essentially the same model to attempt to turn a profit on foreign exchange investing.

Foreign Exchange Hedging

The above example is technically called hedging. It describes the process in which a company will use a foreign exchange option to protect its position on a trade that is not related to the stock market. This is particularly important for companies that deal with more volatile foreign currencies, where the country's credit rating or currency could change drastically in a few days. For example, companies importing goods from a country in South America will be particularly concerned they could lose a substantial amount of profit if the country received a credit downgrade, reducing confidence in foreign investment and quickly dropping the exchange rate of the currency.

Key Terms

While a foreign exchange option seems straightforward, there are a number of complicated terms used in the analysis of these contracts. The term "notional" in a contract is simply used to describe the current price of the security in the contract. It can also be used to describe the strike price. In an options contract, there are two notionals, one representing the price in each currency. The "ratio of notionals" is a fancy term used to describe the relationship between these two prices. For example, in our above example, the ratio of notionals was 1:1. 

The payoff for most options contracts, commonly called vanilla options, is linear. It can be expressed through a simple algebraic expression in which a change of one to the underlying variable will result in a change of one for the eventual payout or loss. Foreign exchange options are often non-linear. This means the change of one to a variable may result in a very different change to the potential payment or loss.

blog comments powered by Disqus
Scottrade