Currency options help to reduce the price risk in international transactions.
The abbreviation FX stands for foreign exchange and is commonly used in connection with transactions made in the growing foreign exchange market. As the world becomes increasingly interdependent economically, the the role of the foreign exchange market becomes more crucial. The market for currency option contracts, or currency options, has proliferated greatly for the purposes of both risk hedging and pure speculation.
What is foreign exchange?
Foreign exchange, commonly abbreviated as "FX" or "FOREX," is a market for the purchase and sale of the world's currencies at prices called exchange rates, which are determined by the fluctuating levels of supply and demand for different currencies. Exchange rates express the cost of a given currency in terms of another. For instance, if the cost in U.S. dollars of purchasing 10 U.K. pounds sterling is $15.00, then the exchange rate is expressed as 1.5 USD/GBP (U.S. dollars per U.K. pound sterling).
What is the role of the foreign exchange market?
The widespread removal of trade barriers and tariffs since the latter half of the 20th century has resulted in what has been termed "globalization," which is to say a growing tendency toward a worldwide economy of interdependent national markets. Enhanced by networks like the World Wide Web, international trade and growth in offshore securities investing have brought the foreign exchange market to the fore. Without this market, trade and investment across international borders would not be possible.
What is an option?
An option is a financial derivative contract that gives the holder the non-obligatory option to buy or sell some quantity of a specific asset (underlying asset) at a predetermined price (strike price) on a particular date (expiration date). Despite the wide variety of options styles, all options are classified as "call" or "put." Call options hedge that the price of an asset will rise, while put options hedge that an asset's price will decline. If the holder's suspicion is correct in either case, he or she may exercise the option to purchase (call) or sell (put) some quantity of the asset in question. If the asset price does not move as expected, then the option expires, having no value.
What is a currency option?
A currency option is an option contract that uses a foreign currency as the underlying asset, giving the holder the option to buy or sell the currency at a specific exchange rate against another currency (usually the home, or base, currency of the holder). For instance, if an investor holds USD and believes that the exchange rate against GBP will decline, he or she may purchase a call currency option. If the investor's forecast is correct, this will allow the investor to exchange USD for GBP at an advantageous rate.
Why currency options?
At a practical level, companies and all manner of investors have incorporated currency options into their portfolios. The foreign exchange market now operates on a near continual basis, and individual exchange rates fluctuate from moment to moment. Consequently, foreign exchange has become increasingly risky, and currency options have become an affordable method for hedging losses associated with unfavorable currency price movements. As a speculative tool, currency options offer investors with strong convictions about price movements the opportunity to capitalize and make potentially astronomical profits from favorable changes in exchange rates.
