As we noted in earlier posts, the currency forward market is quite large. The same is true for the currency options market. A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate, Many companies, knowing that they will need to convert a currency X at a future date into a currency Y, will buy a call option on currency Y specified in terms of currency X. For example, say that a U.S. company will be needing €50 million for an expansion project in three months. Thus, it will be buying euros and is exposed to the risk of the euro rising against the dollar. Even though it has that concern, it would also like to benefit if the euro weakens against the dollar. Thus, it might buy a call option on the euro. Let us say it specifies an exercise rate of $0.90. So it pays cash up front for the right to buy €50 million at a rate of $0.90 per euro. If the option expires with the euro above $0.90, it can buy euros at $0.90 and avoid any additional cost over $0.90. If the option expires with the euro below $0.90, it does not exercise the option and buys euros at the market rate.
Note closely these two cases:
Eum expires above $0.90
Company buys €50 million at $0.90
Eum expires at or below $0.90
Company buys €50 million at the market rate
These outcomes can also be viewed in the following manner:
Dollar expires below €1.1111, that is, €1 > $0.90
Company sells $45 million (€50 million X $0.90) at € 1.1 1 1 1, equivalent to buying €50 million
Dollar expires above €1.1
11 1, that is, €1 < $0.90
Company sells sufficient dollars to buy €50 million at the market rate This transaction looks more like a put in which the underlying is the dollar and the exer- cise rate is expressed as €1.1 11
1. Thus, the call on the euro can be viewed as a put on the dollar. Specifically, a call to buy €50 million at an exercise price of $0.90 is also a put to sell €50 million X $0.90 = $45 million at an exercise price of 1/$0.90, or €1.11 1 1.
Most foreign currency options activity occurs on the customized over-the-counter markets. Some exchange-listed currency options trade on a few exchanges, but activity is fairly low,