Foreign currency options are based on foreign currency values as compared to the U.S. Dollar. Investors use these options to speculate on currency values and hedge against currency exchange risk. We discussed this risk originally back in the foreign investments chapter. If you need a quick refresher, here’s a video discussing currency exchange risk:
Let’s first take a look at some examples of foreign currency option quotes:
1 long Euro Sep 1.15 put @ 4
This long put provides the right to the investor to sell 10,000 Euros at $1.15 U.S. Dollars per Euro. If the Euro weakens and goes below $1.15 U.S. Dollars per Euro, the put goes “in the money,” and the investor gains intrinsic value.
While the multiple for equity options is 100, it’s 10,000 for most foreign currency options. The only exception is Japanese Yen options, which maintain a multiple of 1,000,000. What exactly does this mean? Each option provides a return based on the number of units each option covers. The Yen is a heavily utilized world currency, but its value per unit is low as compared to the U.S. Dollar. For context, ¥10,000 equals $67 at the time of this writing.
In most cases, you won’t need to worry about the 1,000,000 unit multiple of Yen, unless it’s a question directly asking about unit size.
1 long Euro Sep 1.15 put @ 4
In our example above, the option’s profit potential is based on the ability to buy 10,000 Euros at $1.15 per Euro. The investor is betting the Euro will weaken (decline in value) below $1.15 per Euro.
With the difference in unit sizes for foreign currency options, premiums are viewed differently. A premium of 4 is still $400 overall, but the premium is quoted in cents. $0.04 x 10,000 = $400. This is a minor point; you’ll answer foreign currency option questions on the premium correctly if you continue to treat the premium like a typical option (a premium of $4 means $400).
Hedging against currency exchange risk is a common use of foreign currency options. If you’ve even taken an international trip, you probably know the risks of currency exchanges. Let’s think through a few examples:
The U.K.'s currency is the British Pound. You look at the currency value a few months before your trip and find the British Pound is trading for $1.30. Converting your U.S. Dollars to British Pounds will cost you $1.30 per Pound.
For illustration purposes, let’s assume you’ll stay several weeks in London and plan to spend around £10,000 while you’re there. How much is that in U.S. Dollars, assuming the current exchange rate?
£10,000 x $1.30 per pound = $13,000
£10,000 = $13,000
By doing some quick math, a £10,000 vacation in British Pounds will cost $13,000 U.S. Dollars.
What if, just before your trip, the British Pound strengthens to $1.50?
£10,000 x $1.50 per pound = $15,000
£10,000 = $15,000
You’re spending the same amount of British Pounds, but the trip got more expensive due to currency exchange fluctuations. In this case, the Pound strengthening increased the cost of your trip by $2,000 U.S. Dollars. This is currency exchange risk.
If you were very concerned about this risk, you could hedge (protect) yourself. Similar to what we learned in the hedging strategies chapter, investors hedge themselves with long options.
To protect yourself against the British Pound strengthening (rising) in value, you could go long a British Pound call:
Long 1 Dec British Pound 1.30 call @ 3
For a $300 premium, you can obtain some protection. If the British Pound strengthens above $1.30, your option gains intrinsic value and offsets your losses. Using this example, let’s take a look at these typical option questions:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at $1.50
The further the British Pound rises above $1.30, the more intrinsic value the option gains. The higher the intrinsic value, the more the investor receives from the writer when they exercise. Like all other non-equity options, foreign currency options obligate the writer to pay the “in the money” amount in cash to the holder upon exercise.
Like all other options, a premium of 3 means $300. However, foreign currency options are denominated in multiples of 10,000 (except for Japanese Yen), and the premium is quoted in cents. Therefore, $0.03 x 10,000 = $300.
If the British Pound stays below $1.30, the option is “out of the money” and expires worthless. The investor loses their premium and obtains no return (no exercise).
Remember, foreign currency option premiums are quoted in cents. Beyond that, treat the contract like you usually would with any other option! Breakeven for calls is still the strike ($1.30) plus the premium ($0.03). If the British Pound strengthens to $1.33, the investor gains $300 ($0.03 x 10,000) of intrinsic value, offsetting the $300 premium paid upfront.
If the British Pound rises to $1.50, it’s “in the money” by $0.20. The writer must deliver $2,000 ($0.20 x 10,000) to the holder at exercise. Factoring in the $300 premium paid up front, the investor has an overall profit of $1,700.
In our U.K. trip scenario above, you lost $2,000 because the British Pound strengthened from $1.30 to $1.50. A long British Pound 1.30 call offsets this risk (by $1,700), resulting in an overall loss equal to the premium paid ($300). This is why some people hedge themselves against currency exchange risk.
When encountering a math-based foreign currency option, treat it like a normal equity option as much as possible. The numbers are utilized slightly differently, but it’s all the same fundamentals.
Currency options are not available for every currency. In particular, there is no U.S. Dollar currency option because currency options are denominated in U.S. Dollars. $1 U.S. Dollar is always equal to $1 U.S. Dollar. Therefore, it’s useless to utilize U.S. Dollar currency options. Understanding this concept is important for a question like this:
A US exporter is concerned about currency value fluctuations reducing the profit made on a sale of steel to a Japanese exporter. Payment for the steel is made in Japanese Yen. What currency option will properly hedge the exporter?
A) Long USD calls
B) Long Yen calls
C) Long USD puts
D) Long Yen puts
Answer = D) Long Yen puts
First, no U.S. Dollar option exists, so you can quickly eliminate answer choices A and C.
The exporter is concerned about the Yen weakening against the U.S. Dollar (or the Dollar strengthening, which is the same thing). If this occurs, it will take more Yen to convert into the same Dollar (fewer U.S. Dollars received when converting from Yen), reducing the exporter’s profits. Therefore, the exporter should buy the option that profits if the Yen weakens (declines in value). The long put is bearish and will gain intrinsic value if this occurs.
There’s one more way to look at it. The American exporter is being paid in Yen and needs to convert it back to Dollars. Ask yourself what the exporter is doing with the foreign currency. The exporter must sell Yen and use the proceeds to buy Dollars. Therefore, they should go with the option that aligns with this action. The long Yen put provides the right to sell Japanese Yen at a fixed price. Therefore, the long Yen put is the answer.
Other than the multiples (units per currency) quoted in cents, foreign currency options are similar to other options, including these characteristics:
Expiration
Settlement
Market sentiment
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