Currency Options represent a good solution for Importers or Exporters who wants to hedge their foreign currency risks and, at the same time, be able to benefit from favourable currency fluctuations.
Currency Options are contracts, which give the right, but not the obligation to buy or sell a foreign currency at a predetermined exchange rate, at a given date or within a specific period of time.
Note that there are different types of Options among which we can find:
European Options: could be exercised at maturity only
American Options: could be exercised any time before maturity
Bermuda Options: could be exercised on predetermined dates
Please be advised that the below demonstrations are based on European options
Let ‘s suppose that a French Exporter who concluded a 10 000 000 USD deal (9 451 081 EUR) with US company with a 60-day payment terms with an exchange rate of 1 USD = 0.9451 EUR. Since he wants to cover his currency risk and be able to benefit from the USD appreciation, he decided to purchase a currency option.
Since the Exporter wants to avoid the depreciation of the Dollars he will purchase a put option. The broker / banker will sell this option with the following characteristics:
Option: CALL EUR PUT USD (buy EUR and sell USD)
Strike price: 1 USD = 0.95 EUR (exercise price)
This is the price at which the Exporter will be able to sell the USD against EUR
Premium: 2.76 cents or in total 276 000 EUR (10 000 000 * 2.76/100)
Fees charged to the Exporter for the service provided.
Maturity date: 60 days from purchase option agreement
This is the date beyond which the option expires.
In this case the holder of a PUT option will have the right to sell at maturity 10 M USD against EUR at an exchange rate of 1USD = 0.95 EUR.
If when the payment received by the exporter, the exchange rate becomes 1USD = 0.99 EUR then the option will not be exercised. Indeed in this case, he will be better off by using the spot market rate which will gives him 9 900 000 EUR (10 000 000* 0.99) instead of 9500 000 EUR (10 000 000 * 0.95). However in order to establish the net gain, the premium will have to subtracted since it has been paid without being exercised. Therefore, the net gain is 172 919 EUR (9 900 000 – 9 451 081 – 276 000).
On the other hand if the exchange rate becomes 1USD = 0.90 EUR then the Exporter will exercise his option. By doing so, he will get 9 500 000 EUR (10 M USD * 0.95) instead of 9 0000 000 EUR (10M USD* 0.90).
In this case, the exporter avoided the risks engendered by the foreign currency by paying an option which costed 276 000 EUR.
Let’s suppose that a German importer concluded a 10 M GBP deal (11 564 000 EUR) with a UK company with a 90-day payment term at an exchange rate of 1GBP = 1.1564 EUR. In this case, the importer can benefit from the depreciation of the GBP but will be adversely impacted by its appreciation.
Therefore, he will purchase a call option, which will give him the right, but not the obligation, to buy the GBP at a fixe exchange rate with the following characteristics:
Option: PUT EUR CALL GBP (Sell EUR and Buy GBP)
Strike price: 1GBP = 1.17 EUR
This is the price at which the Exporter will be able to sell the USD
Premium: 2.64 cents or in Total 264 000 EUR (10M* 0.0264)
Maturity date: 90 days from purchase option agreement date
Let’s suppose that the exchange rate becomes 1GBP = 1.30 EUR at the time of the payment. Without the option, the Importer would have had to pay 13 M EUR instead of the initial 11,564 M EUR. However by purchasing the mentioned option, the option holder has secured a 1GBP =1.17 EUR exchange rate and as result, he will get the 10 M GBP against 11 700 000 M EUR from which the cost of the option will have to be added (264 000 EUR).
Conversely, if the foreign currency depreciates and becomes 1GBP = 1.08EUR, the importer will not exercise the option. Indeed, in this case the Importer will be better off, by purchasing the foreign currency at the spot market price since he can get 10M GBP for 10.8 M EUR while by exercising his option this will cost him 11.7 M EUR.
In short, the exporter avoided the risks engendered by the foreign currency by paying an option, which costed 264 000 EUR.
Overall currency options enable Importers and Exporters to avoid foreign currency risks while keeping the opportunity to benefit from favourable exchange rates fluctuations.