FX Options

 

Summary:

• An FX option is a contract that gives the holder the right, but not the obligation, to exchange currencies at a set rate (strike price) on or before a specific date.
• Forex options enable businesses to effectively manage currency risk.

 

FX options explained:

• FX options trading
• Terms for FX options
• FX options pricing
• How FX options work: A practical example
• Advantages & disadvantages of FX options

 

FX options trading

An FX option, also known as forex options, are financial derivatives traded over-the-counter (OTC) or, less commonly, exchange traded. FX options grant the holder the right, but not the obligation, to exchange a specified amount of one currency for another at a predetermined exchange rate (strike price) on or before a specified expiration date, depending on the type of option.

A key difference between options contacts to futures and forwards is the ability to exit the trade if a better exchange rate is available in the open market. This allows businesses to mitigate downside risk while preserving some upside potential, however option contracts often carry high premiums which isn’t reimbursed if the trade is not settled.

 

Terms for FX options

Strike price: The predetermined price at which the asset can be bought or sold.

Notional principle: The fixed amount of a currency that is being bought or sold.

Spot price: The current market price at which an asset can be bought or sold for immediate delivery.

Call option: The right, but not the obligation, to buy an underlying asset at the strike price before expiration.

Put option: The right, but not the obligation, to sell an underlying asset at the strike price before expiration.

Intrinsic value: The difference between the current exchange rate of the asset and the strike price of the option, when it is favourable.

Time value: Part of the options pricing that relates to the time remaining until it’s expiry.

 

FX options pricing

Trading FX options requires paying a premium upfront, this consists of two components: intrinsic value and time value.

 

Intrinsic value

The intrinsic value of an FX option is calculated as the difference between the current exchange rate and the option's strike price, only if the option is in the holder's favour.

Intrinsic value = (strike rate – spot rate) * notional principle

If the current exchange rate does not favour the holder, the intrinsic value is zero, meaning the option is out-of-the-money.

 

Time value of FX options

The time value of an option refers to the additional value derived from the time remaining until the option's expiry. It is a crucial factor in pricing options and is influenced by multiple factors, including:

Expiry: The time value of an option typically decreases as the expiry date approaches, a phenomenon known as time decay. As the expiry draws nearer, the likelihood of significant market movements decreases, which reduces the option's premium.

Interest Rates: Interest rates can influence the time value of FX options. Generally, currencies with higher interest rates may lead to a higher time value because the cost of carry (the cost or benefit of holding a position) is more favourable for the currency with the higher rate.

Market Volatility: High levels of market volatility increase the potential for significant exchange rate movements, both favourable and unfavourable. This heightened uncertainty raises the time value of an FX option, as the option's premium reflects the increased likelihood of significant price fluctuations, which enhances the potential value of the option.

 

How FX options work: A practical example

 An investor is selling an asset worth $10 million and expects to convert this to GBP in one year.

To protect against negative currency rates, the investor decides to purchase an FX option at a strike rate of 0.78, with a one year expiry date.

Outcome one: Favourable strike price

On the completion date the USD/GBP has an exchange rate of 0.77, making the strike price of 0.78 more favourable. The investor therefore exercises the option:

Strike price of option: £7.8M

Spot rate: £7.7M

Intrinsic value of the option =  (strike rate – spot rate) * notional principle

$10m * (0.78 – 0.77) = £100,000

 

Outcome two: Unfavourable strike price

On the completion date the USD/GBP has an exchange rate of 0.79, making the strike price of 0.78 less favourable, therefore the investor doesn’t exercise the option and instead exchanges the currency via an FX spot transaction.

Option: $10M * 0.78 = £7.8M

Spot rate: $10M * 0.79 = £7.9M

The investor does not profit on the transaction and loses the premium paid up-front to purchase the FX option.

 

Outcome three: Matches the strike price

On the completion date, the USD/GBP has an exchange rate of 0.78, matching the strike price of the FX option. The FX option therefore has no intrinsic value.

Option: $10M * 0.78 = £7.8M

Spot rate: $10M * 0.78 = £7.8M

Intrinsic value: £0

 

Advantages & disadvantages of FX options

Advantages:

Minimal risk: The buyer of option is not obliged to buy/sell an asset, therefore the maximum loss is the premium used to secure the option.

Potential for large profits: If the currency pair the option is secured against favourably moves, there is a large potential for profit.

Flexibility: The holder has the option to either exercise the option or pull out from the option contract.

 

Disadvantages:

Expensive: The initial upfront premium is often high, especially during periods of high volatility, and it is not reimbursed if the trade isn't settled.

Complex solution: Rules, regulations and pricing surrounding FX options can be complicated