Currency options explained-Types, advantages/disadvantages and example

Published on Friday, August 24, 2018 by Chittorgarh.com Team | Modified on Monday, March 11, 2024

Currency Options have developed into a new asset class for investors. Currency options offer investors the opportunity to monitor exchange rates and use them for investment and hedging.

Currency Options Meaning

A currency option is a derivative contract that gives the buyer of the option the right, but not the obligation, to buy or sell the currency at a specific time and a predetermined price. The seller of the contract is obliged to fulfil the contract if the contract is exercised. The dynamics and mechanism of currency option trading are very similar to equity options. In every currency transaction, one currency is bought and another sold.

There are two types of currency options: Call and Put. A call option gives the right to buy, a put option gives the right to sell. Each transaction involves the purchase of one currency and the sale of another.

Currency options in India are European in nature, which means that the contracts can either be settled by taking an opposite position or exercised at expiry.

The currency options are traded on the NSE and the BSE. The market is regulated by the RBI and SEBI.

Currency Options Types

There are four types of currency pairs for currency options trading:

1. USD-INR
2. EUR-INR
3. GBP-INR
4. JPY-INR

Lot Size: The lot size varies depending on the currency pair. For USD-INR, 1 lot size corresponds to 1000 USD. For EURINR, 1 lot size corresponds to 1000 EUR. For GBPINR it is 1000 GBP and for JPYINR it is 10000 JPY.

Underlying: The underlying is the exchange rate in Indian rupees for each currency pair.

Exercise Style: European, i.e. the contracts can either be closed out by taking an opposite position or exercised at maturity.

Tick Size: The strike price interval in these contracts is Rs 0.25.

Contract Cycle: There are three monthly contracts and 1 quarterly contract.

Margin: Premium for buying and SPAN + Exposure margin for selling

Expiration day: Two days before the last working day of the month.

Currency Options Advantages and Disadvantages

Currency options can offer several advantages to traders and investors who want to speculate or manage currency risk. However, they also have some disadvantages. Here are some of the pros and cons of trading currency options:

Currency options advantages

• Low entry costs. You have to pay a small premium to enter the currency option, as the entry costs are very low.
• Flexibility. Currency options offer the buyer flexibility, as he has the right to exercise the option, but this is not an obligation.
• Protects against unfavourable exchange rate fluctuations. This type of hedging can be particularly useful for companies that need to make payments in foreign currencies in the future but do not know what the exchange rate will be at that time.
• Used to speculate on the future development of a currency's exchange rate. An investor may choose to trade currency options if he believes a currency will appreciate, he may buy a call option. If he believes it will depreciate, he can buy a put option.

Currency options disadvantages

• They are subject to time decay. This means that their value decreases as the expiry date approaches.
• If the market moves contrary to the forecast, the loss can be very large.
• Complexity. Currency options can be complex instruments and may not be suitable for all investors.
• There is always a potential counterparty risk when entering into financial contracts of any kind.

Currency options example

Suppose, a company exports agricultural products to a European country, with revenue denominated in EUR. The company expects revenue in EUR after three months and hopes to make a profit.

• If the foreign currency EUR appreciates in the meantime, the company benefits from the stronger currency when it converts its profits into Indian rupees and suffers the loss of the premium paid to buy the option.
• However, if the foreign currency weakens against the local currency INR (i.e. INR strengthens against EUR), the currency option purchased by the investor ensures that the company can convert its profit into Indian rupees at the predetermined rate, i.e. the strike price.

Currency Options Pricing

A solid understanding of the factors that influence forex options pricing is important so that you can take advantage of price movements and maximize your profits from trades. 5 key factors influence the premium of call and put currency options: Foreign exchange rate, strike price, interest rate, time to expiration, and volatility. Read more here.

Currency Options Breakeven

The break-even spot price is calculated by adding the strike price and the premium.

Currency Options Settlement

On the expiry date, all open long contracts in the money on a specific strike price of a series would be automatically exercised at the final settlement price at the close of trading and randomly assigned to open short positions on the same strike price and series.

• Currency options expiry: The option contract would expire on the last working day (except Saturdays) of the contract month.
• Settlement day: The last working day is the same as for interbank settlement in Mumbai. The rules for interbank settlement, including the rules for 'known holidays' and 'subsequently declared holidays', are as per the rules laid down by FEDAI.
• Settlement price: The final settlement price is the reference rate of the Reserve Bank of India on the date of expiry of the contracts.
• Settlement mechanism: All options contracts are cash settled in Indian Rupee.

Difference Between Equity, Commodity & Currency Options

Currency options are similar to equity options but are vastly different from different from commodity options.

Difference Between Currency Options and Currency Swaps