Foreign Currency Option
What is a Foreign Currency Option?
A Foreign Currency Option is a “hedging tool” that gives the Option holder the right, but not the obligation, to buy or sell a currency at a specified price on or before a specific date in the future. In the case of a Put, the Put holder has the right, but not the obligation, to sell a specific currency. In the case of a Call, the Call holder has the right, but not the obligation, to buy a specific currency.
What are the benefits/risks?
Like Forward Contracts, Foreign Currency Options eliminate the spot market risk for future transactions. Unlike Forward Contracts, they do not oblige you to transact if the spot rate is more favourable than your Option’s strike price. As the name implies, you have the option to transact or not. Purchasing an Option requires the upfront payment of a premium.
An example
You purchased inventory from a company in the United States and payment is due in three months. As a U.S. Dollar buyer, you can buy a three-month Canadian Dollar Put Option to protect against the risk of a decline in the Canadian Dollar. As a U.S. Dollar buyer, you will know with certainty the highest price you will have to pay to sell Canadian Dollars (buy U.S. Dollars). You can also take advantage of a stronger Canadian Dollar over the term of the Option by buying U.S. Dollars in the spot market if there is a favourable exchange rate movement.
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