The only constant in foreign exchange (FX) markets is that they are constantly moving, which means businesses operating across borders face a variety of significant risks from currency fluctuations. Market volatility can negatively impact cross-border payments, growth prospects, the costs of goods and labor and financial forecasting. One way to mitigate these risks is to leverage FX options, also known as currency options.
Currency hedging tools, such as options contracts, empower many multinational — and small or medium-sized — companies with the ability (but not necessarily the obligation) to buy or sell at a specified exchange rate in the future to limit downside exposure and benefit from favorable rate movements without the upfront cost. The strategy can be incredibly valuable for a multitude of cross-border industries, including travel, energy and manufacturing.
What is a vanilla currency option?
The simplest form of currency option is known as a vanilla option. It is a financial derivative contract that gives the buyer the right, but not the obligation, to trade one currency for another at a specified exchange rate at a predetermined expiration date, by paying a premium for the option. At that expiration date, the buyer of the vanilla option can choose to either exercise their option, thereby protecting against unfavorable movements in exchange rates, or let it lapse and instead trade in the open market if it is more advantageous to do so.
As an example, a U.S. company that manufactures its products in Germany would need to sell US dollars and buy euros to cover manufacturing costs. If the dollar were to weaken relative to the euro, those costs would be more expensive in dollar terms and the company’s profit margins would shrink. Conversely, a stronger dollar would reduce the effective cost of manufacture in euros and profits would increase.
Using a vanilla option, however, could be a useful way to manage this risk. It gives the manufacturer the choice of whether to exercise its right sell dollars and buy euros at a specified exchange rate (called the protection rate) at the expiry date, if the dollar is weaker the company can exercise its right to trade at the protection rate and is protected against the unfavorable move.
Alternatively, if the spot rate is more favorable, the manufacturer can allow its option to expire and deal at the more advantageous spot rate. This right to choose is valuable, and as a result, requires the payment of a premium at the time of entering into the option, to the counterparty that sells the option, such as Convera.
“In today’s volatile financial market, vanilla options can be a valuable hedging tool,” says David Renta, Senior Director, Hedging, Convera. “As they confer the right, but no obligation to trade. During uncertain times like these, we tend to see more companies consider vanilla currency options as a way to simultaneously manage FX risk yet retain the potential to achieve better cash flows.”
Types of FX options
Currency options come in two main varieties. The simplest is called a vanilla option, which we outlined in the manufacturer example above. The second variety is called an exotic option and has more complex conditions than a vanilla option.
Exotic options offer customizable features such as triggers and different payoff conditions to match specific currency hedging strategies. Generally speaking, they offer protection that is contingent on given factors rather than being guaranteed, which means they command a lower premium than a vanilla option. As such, while they can be bought on a standalone basis, they are typically combined with vanilla, or other exotic options to create option structures designed to meet specific hedging objectives and market conditions.
Both vanilla and exotic options are described as ‘calls’ or ‘puts’ which illustrates which side of the market you are on. A call option gives the buyer the right to buy a currency pair at a specified exchange rate, known as the strike price, within a certain period. Cross-border businesses typically use call options when they expect the value of the currency pair to appreciate in the future.
Alternatively, a put option grants companies the right to sell a currency pair at a strike price (specified exchange rate) within a given time frame. A business typically leverages a put option when the currency pair is expected to depreciate.
How FX options work
To mitigate currency risk, buyers pay a premium to the seller for the right to trade a currency pair, locking in the maximum loss that the buyer can face if the market moves unfavorably. The contract acts as a type of insurance against adverse exchange rate movements, without taking on the same risk as directly trading the underlying currency pairs.
While the buyer has the option to exercise the contract based on market conditions, the seller is obligated to fulfill the buyer’s decision.
Determining the cost of currency options
To mitigate currency risk, buyers pay a premium to the seller for the right to trade a currency pair, locking in the maximum loss that the buyer can face if the market moves unfavorably. The contract acts as a type of insurance against adverse exchange rate movements, without taking on the same risk as directly trading the underlying currency pairs.
While the buyer has the option to exercise the contract based on market conditions, the seller is obligated to fulfill the buyer’s decision.
Determining the cost of currency options
FX options are purchased with a premium that is typically paid upfront. The premium consists of the intrinsic value and the time value.
The option’s intrinsic value is the difference between the amounts converted using the strike rate and the forward rate, assuming the option is exercised immediately.
Time, or extrinsic, value is the difference between the option premium and its intrinsic value. It represents the value of the optionality – the right to choose – and is greater the further into the future that right extends, the more volatile the underlying market and the more uncertain the potential outcome is.
The break-even spot rate is the exchange rate at which the buyer will break even, accounting for the premium paid. If the market moves favorably, the buyer can exercise the option, but if it moves unfavorably, they can let the option expire, limiting their loss to the premium.
To put it simply, the premium is calculated by determining how likely it is that the buyer of the option will want to exercise their right to deal at expiry. The more likely this outcome, the more expensive the premium.
“This means buyers should expect to pay more if their option is due to expire around a significant market event, such as an election or an interest rate decision,” explains David. “Events of this nature can cause a short-term spike in volatility making the optionality more valuable. Similarly, as uncertainty increases over time, a longer-term option is more expensive than a shorter-term one.”
Key factors that affect FX options
Defining FX risk is incredibly valuable in the ever-changing world of global currencies. Consider several key factors:
- Exchange rates: The biggest factor affecting the value of an FX option is the price of the underlying currency pair. If the spot exchange rate moves in favor of the buyer’s option, the value of the option increases.
- Interest rates: Differences in interest rates between two countries can impact exchange rates and, subsequently, the value of currency options. Higher interest rates generally attract capital inflows, strengthening the currency, while lower interest rates tend to weaken the currency.
- Economic indicators and inflation: Key economic data, such as GDP growth, employment figures and inflation, can influence currency values. A country with strong economic performance and low inflation tends to have a stronger currency.
- Strike price, premium and expiration: The agreed-upon exchange rate, the cost of the option and the predetermined time frame play significant roles in the pricing of currency options. The closer the option is to expiration and the further the strike price is from the premium, the less likely the option will be exercised.
- Market sentiment: General market sentiment, geopolitical risks and speculative pressures can drive currency volatility, impacting currency options.
“The financial outcome of entering any type of currency option contract or structured option is dependent on a wide variety of factors, from the impact of market events on currencies, through to the amount of time the contract remains active. It’s important that companies work with a risk management specialist to ensure they understand all the potential outcomes,” said David.
Benefits of FX options
Currency options offer a range of benefits for organizations across industries. A primary advantage is the ability for companies to hedge against currency risk, helping protect themselves against potential losses due to fluctuations in exchange rates while remaining within their budget. This strategy can be particularly useful for businesses that operate in multiple currencies or for companies that hold assets denominated in foreign currencies.
Another benefit of options contracts is the ability to lock in a budgeted rate while retaining the ability to participate in favorable rate movements.
FX options offer flexibility and customization. Businesses can choose from a range of strike prices, expiration dates and contract sizes to suit their specific needs, tailoring their trading strategy to their goals and risk tolerance.
For example, zero-cost options are tailored to the buyer’s needs and requirements as well as market conditions. Generally, they involve the simultaneous purchase and sale of two or more options. The business buys the protection that they require with one option and, instead of paying a premium, they sell another option with an equivalent value to the other party.
FX options also come with associated risks
It’s important that businesses understand that currency hedging tools are derivative financial instruments that may expose them to risk, should the underlying exposure they are hedging cease to exist. FX options may be suitable for your business objectives, if you have a high level of understanding and accept the risks associated with derivative financial instruments that involve foreign exchange and related markets.
If you are not confident about your understanding of derivative financial instruments, or foreign exchange and related markets, it is strongly suggested you seek independent advice before deciding to use these instruments.
Industries that can benefit from currency options
A range of industries could benefit from FX options, especially those that are heavily involved in international trade and operations. Some examples include:
- Manufacturers sourcing materials or selling products internationally can use currency options to hedge against fluctuations in the value of foreign currencies.
- Travel companies can help protect themselves from changes in foreign exchange rates that could affect their pricing structures and cash flows.
- Energy companies with cross-border contracts can mitigate currency risk when dealing with revenues or expenses denominated in foreign currencies.
FX options vs. FX forwards
While companies use both currency options and forward contracts to manage currency risk, these financial instruments have key differences.
A forward contract doesn’t have an upfront cost, but it obligates both parties to buy or sell a currency at a specified exchange rate on a specific future date. Unlike options, forward contracts don’t provide the flexibility to opt out, and they require the full settlement of the contract at maturity. If the market moves in the buyer’s favor, they cannot benefit from the market movement.
In contrast, currency options offer the right — but not the obligation — to buy or sell a currency pair at a specified exchange rate. The buyer has the flexibility to choose whether or not to exercise the option, limiting the downside risk to the premium paid.
Companies looking for flexibility may find currency options to be a more suitable choice than forward contracts that lock them into a fixed commitment.
Those looking for a combination of zero cost protection and some degree of participation, on the other hand, could consider structured or zero cost options.
Other use cases for currency options
While FX options can be used to hedge against price fluctuations, they can also be useful when the underlying cash flow itself is uncertain.
A company tendering for a contract that generates significant exposure to foreign currencies might use a vanilla option to protect itself from potential losses due to exchange rate fluctuations whilst retaining the ability to let the contract lapse if they don’t win the tender and therefore don’t have the currency exposure.
Currency options are therefore also a way of retaining flexibility. By locking in favorable exchange rates while retaining the ability to benefit if the market moves in its favor, businesses have more paths to better cash flows than simply paying or receiving money at the relative values of each currency on a given day.
Boost your cross-border cash flows
Understanding how currency options work and how to trade them can help mitigate currency risk and improve financial stability for companies operating in global markets. However, it is important to understand how these tools work and the risks associated with their use, by working with a specialist provider.
To explore more about how currency options can benefit your cross-border business growth, Convera, a commercial payments company, offers tailored risk management solutions that help you navigate the complexities of foreign exchange markets.
Contact our FX risk management experts today and start taking control of your currency exposures.
Convera’s hedging products are derivative financial instruments which may expose you to risk should the underlying exposure you are hedging cease to exist. They may be suitable if you have a high level of understanding and accept the risks associated with derivative financial instruments that involve foreign exchange and related markets. If you are not confident about your understanding of derivative financial instruments, or foreign exchange and related markets, we strongly suggest you seek independent advice before making the decision to use these instruments.
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