Currency Options: An Overview

Options on foreign exchange or forex options are similar to options on shares or even real estate in that they confer upon the option buyer the right, but not the obligation, to enter into a contract with the seller. Naturally, the option owner exercises this right that they pay a price or “premium” for only when it is to their advantage. Furthermore, currency options specify an underlying foreign exchange contract and give their buyer the right to enter into that specified contract during (for American-style options) or at the end of (for European-style options) a pre-determined period of time.

Nevertheless, forex options differ somewhat from stock options in that their underlying contract is an exchange of one currency for another, rather than a simple stock transaction. As a result, all forex options are simultaneously the right to buy or “call” one currency and the right to sell or “put” the other currency.

Forex options are also distinguished by the fact that the underlying currencies have more or less continuous interest rates, rather than discontinuous dividends like stocks. Accordingly, the interest rate differential between the currencies is used to evaluate currency options, along with other market parameters (like the prevailing spot rate, forward rate, and implied volatility), and the specified underlying contract parameters (like transaction or “strike” price, maturity or “expiration” date, and which currency is to be bought and which sold in the exchange).

Currency options have gained widespread acceptance as invaluable tools for managing foreign exchange risk, and they currently make up between 5-10% of total foreign exchange market turnover. In addition, options offer a unique risk profile, as well as the potential for combining options of different strike prices and maturity dates to create a customised trading or hedging strategy. These characteristics of currency options considerably widen the range of strategic alternatives available to the portfolio managers, traders and corporate treasuries who use them.

This area of OzForex devotes its discussion to furthering the understanding of what currency options are, how they are priced, and how they can be used to enhance a foreign exchange trading or hedging program. In the near future, OzForex will also be offering options pricing tools, in addition to a section that simplifies the mathematics behind options pricing, as aid to assist risk managers and traders in evaluating this especially useful forex product.

Contact us now to discuss your individual FX Options needs with our accredited dealers and get a currency option quote.

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