UNIT 5: Currency Options (CO5) – Detailed Answer

1. Features of Currency Options

Currency options are financial derivatives that give the buyer the right, but not the obligation, to
buy or sell a specified amount of foreign currency at a pre-determined price (strike price) on or
before a specified date. They are widely used in international finance for hedging and speculation.

Paragraph Explanation:
Unlike forward contracts, which bind both parties, currency options provide flexibility to the buyer.
The buyer can exercise the option if it is profitable and let it expire if it is not. The seller (writer) of
the option receives a premium as compensation for taking on the risk. Options can be European
style (exercise only at expiry) or American style (exercise any time before expiry). The underlying
asset is usually a foreign currency pair like USD/INR, EUR/USD, etc.

Key Features in Points:

 Right Without Obligation: Buyer can choose to exercise.

 Call Option: Right to buy currency at strike price.

 Put Option: Right to sell currency at strike price.

 Premium: Cost paid by the buyer.

 Strike Price: Predetermined price.

 Expiration Date: Last date for exercising.

 Standardization and Market: Can be OTC or exchange-traded.

 Leverage: Small premium controls a large currency value.

Example:
An Indian importer needs $50,000 in three months. They buy a call option at strike price ₹83/$,
paying a premium of ₹0.50 per USD. If the spot rate rises above ₹83, the importer exercises the
option; if it falls below ₹83, the option is not exercised, and loss is limited to premium.

2. Terminology of Currency Options

Understanding terminology is crucial to use options effectively:

Paragraph Explanation:
The call option gives the right to buy currency, while the put option gives the right to sell. The strike
price is the fixed rate agreed in the contract. Premium is the upfront payment for obtaining this
right. Options are classified as in-the-money (ITM), at-the-money (ATM), or out-of-the-money
(OTM), depending on the relationship between the spot price and strike price. ITM options are
profitable to exercise; OTM options may expire worthless.

Key Terms in Points:

 Call Option: Right to buy foreign currency.

 Put Option: Right to sell foreign currency.

 Strike Price: Price agreed in contract.

 Premium: Payment to seller for option.

 In-the-Money (ITM): Exercise profitable.

 Out-of-the-Money (OTM): Exercise not profitable.

 At-the-Money (ATM): Strike price = Spot price.

 Expiration Date: Option maturity.

Example:
Spot USD/INR = ₹82

 Call option strike = ₹83 → OTM

 Put option strike = ₹81 → OTM

 Call option strike = ₹82 → ATM

3. Gains and Losses in Currency Options

Paragraph Explanation:
Currency options are asymmetric instruments. The buyer’s risk is limited to the premium paid, while
the seller’s risk can be substantial if the currency moves against them. Gains for buyers of call
options are unlimited if the currency appreciates, whereas losses are restricted to the premium.
Sellers gain premium income but may face large losses in adverse movements.

Points for Gains and Losses:

 Buyer of Call: Maximum loss = premium; potential gain = unlimited.

 Buyer of Put: Maximum loss = premium; potential gain = if currency depreciates.

 Seller of Call: Maximum gain = premium; potential loss = unlimited.

 Seller of Put: Maximum gain = premium; potential loss = substantial.

Example:

 Buyer purchases call option at ₹83/$, premium ₹0.50

 o Spot rises to ₹85 → Profit = ₹85 – ₹83 – 0.50 = ₹1.50 per USD

o Spot falls to ₹81 → Loss = ₹0.50 per USD (premium only)

4. Hedging with Currency Options

Paragraph Explanation:
Hedging with currency options protects businesses from adverse currency movements while
allowing them to benefit from favorable movements. Importers buy call options to lock a maximum
cost if currency appreciates. Exporters buy put options to lock minimum receipts if currency
depreciates.

Points for Hedging Strategies:

 Importer: Buy call option → locks maximum payment

 Exporter: Buy put option → locks minimum receivable

 Cross-Hedging: Using correlated currency options to hedge risk when direct option
unavailable

 Premium Cost: Paid upfront, considered as insurance cost

Example:
Exporter expecting $100,000 in 3 months buys put option at ₹81/$, premium ₹0.50.

 INR depreciates to ₹83 → Gain = ₹83 – ₹81 – 0.50 = ₹1.50 per USD

 INR appreciates to ₹79 → Option not exercised; loss limited to premium ₹0.50

5. Speculation with Currency Options

Paragraph Explanation:
Speculators use currency options to profit from anticipated exchange rate movements. They take
positions (buy call/put) based on their forecast of currency appreciation or depreciation. Options
provide leverage, limited loss (premium only), and flexibility in choosing strike price and expiry.

Points for Speculation:

 Buy call → anticipate currency appreciation

 Buy put → anticipate currency depreciation

 Profit = Difference between spot at exercise and strike price – premium

 Loss = Premium paid if forecast wrong

Example:
Trader expects USD to rise → buys call option at ₹83/$, premium ₹0.50

 Spot rises to ₹86 → Profit = ₹86 – ₹83 – 0.50 = ₹2.50 per USD

 Spot falls → Loss = ₹0.50 premium

6. Summary Table – Hedging vs Speculation

Feature Hedging Speculation

Objective Reduce risk Profit from currency movements

Strategy Buy call/put based on exposure Buy call/put based on forecast

Risk Limited to premium Limited to premium

Gain Protects cash flows Potentially high

Example Exporter locks USD receipt Trader bets USD will rise