Foreign currency options are financial instruments that grant the right to purchase a set amount of one currency at the rate stated in the option on a specific date. The owner of the instrument is not obligated to make the purchase. It is one of the largest options markets worldwide, and is also the most liquid.
Foreign currency options work similarly to a put/call arrangement in the regular stock market. For example, a company might receive an option to use its Mickey Mouse dollars to purchase Donald Duck dollars at some date in the future. The option is to buy 10 Donald Duck dollars for each Mickey Mouse dollar. If, on the date given, one Mickey Mouse dollar will purchase 15 Donald Duck dollars on the current market, the company will likely choose to not exercise its option. Instead, it will make a spot purchase, receiving 15 Donald Duck dollars for every Mickey Mouse dollar. On the other hand, if the disparity goes the other way and now one Mickey Mouse dollar will only purchase 5 Donald Duck dollars, the company will exercise its foreign currency options so that it can receive more.
Corporations sometimes use foreign currency options to guard against uncertain valuations. For example, suppose a company sells a piece of equipment for 10,000 Donald Duck dollars to a client in a company that will be paying in Mickey Mouse dollars. An option can guarantee the company will receive a set amount, regardless of whatever fluctuations occur between the two currencies between delivery and payment.
Foreign currency options require the buyer to pay a premium for the right to purchase the currency in the future at the specified price. The premium is forfeited should the company choose to not exercise the option.
Some companies that are bidding on projects that will be paid in a different currency often use foreign currency options. If their bid is not selected, they do not have to exercise the option, which will expire on the date shown. However, if their bid is successful, they have locked in a profit margin that will not be eroded by any fluctuations in currency.
Foreign currency options protect the buyer, whose costs are established in the beginning. The seller, however, risks the possibility that he could lose a substantial amount of money if the exchange ratio does not go in his favor. In countries where the currency market is volatile, the premium for foreign currency options is greater than in countries where the currency is stable.
The exercise date of foreign currency options depends on the structure of the agreement. Most European options state that the option can only be exercised on the expiration date. Most American options allow the option to be exercised at any time between the date of the agreement and the expiration date.
Foreign currency options are slowly moving into the investment arena. Some cautious investors are using them for speculative purposes. However, the cost of the option limits the number of investors who choose to hedge their bets with options.