Foreign Exchange Option

A foreign exchange option is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any sort in the world.

Most of the foreign exchange option volume is traded OTC and is slightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The world market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158,300 billion in.

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period. For this right, a premium is given to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best means for corporations or individuals to hedge against unfavorable movements in exchange rates.

Investors can hedge against foreign currency risk by buying a currency option put or call. For instance, assume that an investor believes that the USD/EUR rate is going to boom from 0.80 to 0.90. In this case, the investor would want to purchase a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate.

Contract giving the right, not the obligation, to purchase or sell a specific quantity of one foreign currency in exchange for another at a constant price; called the Exercise Price or Strike Price. The purchaser of a currency option pays a premium to the seller. American-style options are exercisable on any date up to the contract ending date; in contrast, European style options only can be exercised at specific future dates.

Foreign currency options for U.S. Dollar, deutschmark, Canadian dollar, British pound, Swiss franc, and Japanese yen are traded over the counter by banks in major financial centers all over the world. Exchange-traded currency options are traded in the United States on the Philadelphia Stock Exchange. OTC trading in several markets coincides with the quarterly expiration cycles-March, June, September, and December-of exchange traded currency options.

Generally in thinking about options, one assumes that one is buying an asset: for example, one can have a call option on oil, which allows him to purchase oil at a given price. One can consider this situation more symmetrically in FX, where one exchanges: a put on GBPUSD permits one to exchange GBP for USD: it is at once a put on GBP and a call on USD.

As a vivid example: people usually consider that in a fast food restaurant, one purchase hamburgers and pays in dollars, but one can instead say that the restaurant buys dollars and pays in hamburgers.

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