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Option Types - Calls Options and Puts Options
PurposeA Call option enables an option buyer to set a maximum price (rate) at which to buy a currency against another currency. A Put option enables the buyer to set a minimum price at which to sell a currency against another currency.
DescriptionA Call option is an agreement between the buyer and the seller of the option whereby the buyer obtains the right but not the obligation to buy an agreed amount of a currency at a pre agreed price (the strike price), on an agreed future date (the value date). The choice of whether to use the option is made on the expiry date, which is 2 business days before the value date. A Put option is in all respect the same except that it confers the right to sell at a pre agreed rate. In return for the option, the buyer pays the seller a premium.
For the remainder of this example lets assume we are referring to a bought GBP Call / USD Put.
SettlementSettlement only occurs if it is advantageous for the buyer to exercise the option. If the GBP appreciates beyond the strike price, the buyer of an GBP Call option will exercise the option and buy GBP/sell USD at the strike price. If the GBP is below the strike price at expiry the buyer will simply let the option lapse.
Typical Uses- A customer wishing to gain protection against an appreciating (strengthening) GBP.
- Customers who are involved in tenders which contain a foreign currency element can protect themselves against adverse currency movements during the time between lodging a tender and receiving notice of its outcome. Should the tender be unsuccessful the maximum cost of hedging is limited to the amount of the premium.
Example - Current PositionYou are a United Kingdom based exporter with a USD 1,000,000 receipt due in three months time. At that time you will need to purchase GBP. The current three month forward rate for GBP/USD is USD 0.6500 (spot rate is also USD 0.6500).
Market OutlookYou are unsure about the future direction of the GBP against the USD. You wish to protect yourself against an GBP appreciation but would like to gain from any favourable rate movement.
Suggested SolutionYou purchase an GBP call option with a strike price of USD 0.6500 for a total premium of USD 15,000. This equates to 1.50 % of the face value of the contract.
ResultIf the GBP/USD exchange rate is above USD 0.6500 you exercise the option. In this case your elective exchange rate will be equal to the strike price plus the cost of the premium. If the GBP/USD is below USD 0.6500 you let the option lapse and buy GBP in the spot
market.
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