Currency Call Options
A currency call option is a contract that gives the buyer the right to buy a foreign currency at a specified price during the prescribed period. Firms buy call options because they anticipate that the spot rate of the underlying currency will appreciate. Currency option trading can take place for hedging or speculation.
- Hedging: Multinational companies with open positions in foreign currencies can utilize currency call options. For example, suppose that an American firm orders industrial equipment form a Indian company, and its payment is to be made in Indian Rupees upon delivery. An Indian rupee call option call option lacks in the rate at which the U.S company can purchase Rupees for Dollars. Such an exchange between the two currencies at the specified strike price can take place before the settlement date. Thus the call option specifies the maximum price which the U.S. company must pay to obtain Rupees. If the spot rate falls below the strike price by the delivery date, the importer can buy Rupees at the prevailing spot rate to pay for its imports and can simply let its call option expires.
- Speculation: Firms and individuals may speculate with currency call options based on their expectations of exchange-rate fluctuations for a particular currency. The purpose of speculation in the call option market is to make a profit from exchange rate movements by deliberately taking an uncovered position. If a speculator expects that the future spot rate of a currency will increase, he makes the following transactions:
- Buy call options of the currency
- Wait for a few months until the spot rate of the currency appreciates high enough
- Exercise his option by buying the currency at the strike price, and
- Sell the currency at the prevailing spot rate.
Currency Put Options
A currency put option is simply a contract that gives the holder the right to sell a foreign currency at a specified price during a prescribed period. People buy currency put options because they anticipate that the spot rate of the underlying currency will depreciate. Multinational companies who have open positions in foreign currencies can employ currency put options to cover such positions. For example, assume that an Indian company which has sold an airplane to a Japanese firm and has agreed to receive its payment in Japanese yen. The exporter may be concerned about the possibility that the yen will depreciate when it is scheduled to receive its payment from the importer. To protect itself against such a yen depreciation, the exporter could buy yen put options, which would enable it to sell yen at the specified strike price. In fact, the exporter would lock in the minimum exchange rate at which it could sell Japanese yen in exchange for U.S. dollars over a specified period of time. On the other hand, if the yen appreciates over this time period, the exporter could let the put options expire and sell the yen at the prevailing spot rate.
Individuals may speculate with currency put options based on their expectations of exchange rate fluctuations for a particular currency. For example, if speculators believe that the Euro will depreciate in the future, they can buy euro put options, which will entitle them to sell euro’s at the specified strike price. If the euro’s spot rate depreciates as expected, they can buy euro’s at the spot rate and exercise their put options by selling these euro’s at the strike price. Speculators do not need to exercise their put options in order to make a profit. They could make a profit from selling put options because put option premiums fall and rise as exchange rates of the underlying currency rise and fall. The seller of put options has the obligation to purchase the specified currency at the strike price from the owner who exercises the put option. If speculators anticipate that the currency will appreciate, they might sell their put options. But if the currency indeed appreciates over the entire period, the put option will mot e exercised. On the other hand, if they expect that the currency will depreciate, they will keep their put options. Then they will sell their put options when the put option premiums go up.