IOE Tradeportal

Current Spot Rates

The Currency Option can be used to hedge either:

the FX risk up to the time Forward FX Contracts can be taken out - Current Spot Rate

Or, if the exporter or importer do not wish to take out Forward FX Contracts,

the FX risk up to date of payment - Forward Spot Rate.

Exporters tendering for large overseas contracts where they have to fix the exchange rate at the time of tendering may find Currency Options valuable in retaining price flexibility and competitiveness.

If the exporter bought a Current Spot Rate Currency Option, then after winning the contract he would enter in a Forward FX Contract or Option Forward FX Contract, having decided whether or not to exercise his Currency Option. He would exercise his Option if the Exercise/Strike Price was more favourable than the Current Spot Rate.

If the exporter had bought a Forward Spot Rate Currency Option, then after winning the contract he would NOT sell his FX receivables Forward but wait until payment was received. He would then decide whether or not to exercise his Option. He would either sell at the then Spot Rate or at the Exercise/Strike Price depending which FX rate was more favourable.

Uncertain Cashflows

Currency Options are particularly useful for hedging currency flows that cannot be forecast with certainty. They can protect against adverse FX movements from the date of tender until the contract is awarded or comes into effect. By this time currency cashflows would be known with some degree of accuracy and Forward FX Contracts can be entered into.

An importer can also benefit from Currency Options. An importer may not know what rate of exchange will apply at the time he is due to make payment until he decides when to place his business. Even then he is dependent on the exporter delivering on time and in line with the buyer's currency payment cashflow. A Currency Option helps minimise his FX rate uncertainty and permits him to take advantage of favourable exchange rate movements.

A Currency Option is, therefore, an alternative FX hedging facility. By providing the right but not the obligation to deliver the currency, the exporter or importer can choose either to exercise the Option or let the Option lapse, depending on what the Spot Rate is on the Exercise Date of the Currency Option.

Types of Currency Option

There are two different types of option:

American style options that can be exercised at any time until their date of expiry.

European style options that have to be exercised only on the agreed date, i.e. on the date that they mature

How a Currency Option protects an Option holder from FX rates falling below the Strike Price (limiting downside risks), but enables him to benefit when the Spot Rate is more favourable than the Strike Price (unlimited upside benefits), can be shown graphically.

A graphical comparison can be made with a Forward FX Contract and Option Forward FX Contract which locks the exporter or importer safely into a fixed FX rate, but eliminates the opportunity to take advantage of favourable FX rate movements.