CIMA BA1 Syllabus D. The Financial Context Of Business - Currency Options - Notes ^{7 / 8}

Features of currency options

A currency option gives its holder the right to buy (call option) or sell (put option) a quantity of one currency in exchange for another, on or before a specified date, at a fixed rate of exchange (the strike rate for the option).

Currency options can be purchased over-the-counter or on an exchange.

In practice, companies buying call or put currency options do so in over-the- counter deals with a bank.

They protect against adverse movements in the actual exchange rate but allow favourable ones!

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

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.

Example

A company is expecting receipt from a foreign currency sale (in $s) in three months’ time and is concerned about the potential impact exchange rate movements could have on the money it receives.

Required

Which of the following statements is correct?

A   A call option in $s would allow the company to fix the rate.

B   A futures contract would allow the company to hedge the exact size of the transaction.

C   A forward contract would remove risk but may be prohibitively expensive.

D   A put option in $s would remove downside risk but would also allow the company to benefit if the value of the $ was significantly higher in three months' time.

• Solution

  Correct answer: D

  A put option is an option to sell $s, which is what is needed. 

  After taking out the contract, the optional exchange rate does not have to be used and if the value of the $ was significantly higher in three months' time then this means that the receipts will be worth more when they are converted at the spot rate. 

  So the option is unlikely to be used.