Currency Option Types – Vanilla Calls and Puts

Purpose

A “vanilla” or standard European or American-style currency option enables its buyer to set a fixed price or exchange rate at which to buy or call one currency and sell or put the other currency. Calls on the base currency are those which can result in the option buyer purchasing that base currency if exercised, and they establish a maximum price or cap at which the buyer can purchase the base currency and sell the counter currency. On the other hand, puts on the base currency can result in the buyer selling the base currency if exercised, and they establish a minimum price or floor at which the buyer can sell the base currency and buy the counter currency. Such options are typically bought for hedging exposures that have some degree of uncertainty involved in terms of the position size or for trading markets when considerable stop-loss risk is involved in holding a medium-term cash position.

Description

A vanilla call option on the base currency 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 the base currency and sell the counter currency at a pre-determined exchange rate, known as the strike price, for delivery on an agreed future date, known as the delivery or value date. The choice of whether to use the option is made on the expiry date, which in the OTC currency option market is usually spot value or two business days before the delivery date (except for USD/CAD options where expiry is usually one business day before the delivery date). A put option is in all respects the same except that it confers the right to sell the base currency and buy the counter currency at a pre-determined rate. The buyer pays the seller a premium in return for obtaining the right conferred by the option. The remainder of this vanilla option example will refer to a purchased European-style AUD call/USD put option.

Settlement

Settlement only occurs if it is advantageous for the buyer to exercise the option. If the AUD appreciates against the USD beyond the strike price of the AUD call/USD put option, the buyer will probably elect to exercise the option and so will buy AUD and sell USD at the strike price. The buyer can also sell the option back to the market on its expiration date to do what is known as a “net cash settlement” to capture the value of the cash difference between the strike price and the underlying market without having to deliver on the underlying foreign exchange contract. Of course, if the AUD is below the strike price at expiry, the buyer will simply allow the option to expire worthless and will instead purchase any AUD they need in the spot market.

Typical Uses of a Purchased AUD Call/USD Put Option Strategy

  1. A hedger who has a short AUD/long USD exposure and who wishes to have protection in place against an appreciating AUD/USD rate, but to still participate in any declines in the AUD/USD rate.
  2. Hedgers who are involved in tenders that 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 paid.
  3. A trader wishing to benefit from a substantial projected medium-term rise in the AUD versus the USD by taking a limited-downside position. 

Example - Current Position

Consider the example of an Australia-based exporter with a USD 1,000,000 receipt due in three months’ time. At that time, they will need to purchase AUD. Both the current spot rate and the three-month forward rate for AUD/USD is USD 0.6500.

Market Outlook

The exporter is unsure about the future direction of the AUD against the USD. They wish to protect against AUD appreciation, but would like to gain from any favourable rate movement if the AUD were to fall against the USD.

Suggested Solution

The exporter can purchase an AUD call option with a strike price of USD 0.6500 and a face value of USD 1,000,000 for a total premium of USD 15,000. This equates to 1.50% of the face value of the contract.

Result

If the AUD/USD exchange rate is above USD 0.6500 at expiration, the exporter will exercise their option. In this case their effective exchange rate will be equal to the strike price plus the cost of the premium paid for the option expressed in pips.

If the AUD/USD is below USD 0.6500, then the exporter will let the option lapse and will instead sell their USD 1,000,000 receipt and buy AUD in the spot market. Their effective exchange rate will then be equal to the spot rate plus the cost of the option in pips.

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