Currency Option Contracts In contrast to a forward or futures contract, an option gives the option

Currency Option Contracts In contrast to a forward or futures contract, an option gives the option

buyer the opportunity to benefit from favorable exchange rate move- ments but establishes a maximum loss. The option price is the cost of establishing such a risk/return profile.

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There are two types of foreign currency options traded on exchanges: options on the foreign currency and futures options. The lat- ter is an option to enter into a foreign exchange futures contract which has the same effect in hedging exposure to currency risk.

There is also an over-the-counter (OTC) market for options on cur- rencies. The markets for these products are made by commercial banks and investment banking firms. OTC options are tailor-made products to accommodate the specific needs of corporate clients. While options on the major currencies are traded on the exchange, an option on any other currency may be purchased in the OTC market.

There are variations on the standard call and put options in the OTC market. These options are called exotic options. Two common types of exotic options on currencies used by firms are the lookback cur- rency option and the average rate currency option.

A lookback currency option is an option where the option buyer has the right to obtain the most favorable exchange rate that prevailed over the life of the option. For example, consider a two-month lookback call option to buy yen when the exchange rate between the U.S. dollar and Japanese yen is $1 for 105 yen on Day 0. Suppose that the next day, Day

1, the exchange rate changes to $1 for 110 yen—the option buyer has the right to exchange $1 for 110 yen. Suppose that on Day 2 the exchange rate changes to $1 for 108 yen. The option buyer still has the right to exchange $1 for 110 yen. Regardless of what happens to the exchange rate over the 60 days, the option buyer gets to exercise the option at the exchange rate that prevailed that gave the largest number of yen for $1 (or, equivalently, at the lowest price per yen).

An average rate currency option, also called an Asian currency option, has a payoff that is the difference between the strike exchange rate for the underlying currency and the average exchange rate over the life of the option for the underlying currency. In the case of a call option, if the average exchange rate for the underlying currency is greater than the strike exchange rate, then the option seller must make a payment to the option buyer. The amount of the payment is:

Payoff for average rate currency call option = (Average exchange rate – Strike exchange rate) × Underlying units

In the case of a put option, if the strike exchange rate for the underlying currency is greater than the average exchange rate, then the option seller must make a payment to the option buyer that is equal to:

Payoff for average rate currency put option = ( Strike exchange rate Average exchange rate – ) Underlying units ×

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