The Basics of Currency Options

What are Currency Options?
Currency options, simply states, are a choice. It gives the buyer the option to the right, but not obligation, to enter into a contract or buy or sell an underlying asset. The option owner general will exercise this right to their advantage. The seller is the only part obligated to act upon request to fulfill the contract. Currency options determine a foreign exchange contract, and give the owner the option, or right, to enter into the specified contract during a pre-determined period of time.
Corporate Treasury managers have accepted currency options as invaluable tools for managing the risk of foreign exchange. The risk in purchasing a currency option is much lower than a currency futures contract, as it is limited to the premium, which you pay without the unlimited risk potential of a currency futures contract.

How are Currency Options Valued?
There are several important components that make up the option premium (price) that you should understand. The elements that are used in the model include the underling asset’s current spot price, the exercise price of the option, the duration of the expiry of the option, the volatility of the underlying asset, the risk-free money rate, and the holding benefit of dividend rate on underlying instruments.
The option premium can be broken down into two parts to make it easier to understand. These are the intrinsic value, and its time value. The premium will be equal to the sum of the two parts, for any option.
Though there are many different types of currency options, there is less confusion once you know the categories they fall into. Fortunately there are only a few. From this knowledge base, more intricate structures are used to meet the needs of the end user.

Types of Currency Options Available
Call and Put Options
In every transaction a currency is purchased and sold. This is also the case with options transactions. A Call option is the right to purchase a currency, and a Put option is the right the sell a currency. If you decided to purchase a Call option in one currency, you are also purchasing a Put option, but in another way. Each currency option is a Call and a Put on the respective currencies being bought and sold, since you cannot do one without the other.

Knock-Out Options
These are like standard options with a slight twist. If they reach a ceiling value they become worthless. If they remain within the level during the life of the option, they still hold value. Because they include the risk of becoming worthless, they are generally cheaper than a standard Call or Put.

Knock-in Options
Knock-in options are the opposite of knockout options. If the underlying market doesn’t reach a certain level before maturity, the normal characteristics of a Call or Put option comes into play.

Average Rate Options
Strikes are determined by an averaging process. This may happen at the end of every month. The difference between the calculated strike and the underlying market at expiry will determine the profit or loss of the option.

Basket Options
A basket option is similar to a stand option, but the strike price of based on the weighted value of the component currencies. This is calculated in the buyer’s base currency. The buyer decides when the option will mature, as well as the foreign currency amounts that make up the basket and the strike price, which is also expressed in units of the base currency.

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