AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2b. Currency Options 10 / 13

Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

vi) Currency options

Currency Options

Features of Currency Options

A currency option gives its holder the right to:

Buy (Call option) the contracted currency or
Sell (Put option) the contracted currency

on or before a specified date, at a fixed rate of exchange (the strike rate for the option).

If the exchange rate moves against you - then take the option which is more favourable
If the exchange rate moves in your favour - then ignore the option (which would be adverse)... You can't lose!

Clearly, because of this, the option involves buying at a premium at the beginning

Disadvantages

  1. The premium

  2. Must be paid up immediately

  3. Not available in every currency

Advantages

  1. Currency options do not need to be exercised if it is disadvantageous for the holder to do so.

  2. Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allow their options to lapse. The initial fee paid for the options will still have been incurred, however.