Foreign currency options are based on the value of a foreign currency relative to the U.S. Dollar. Investors use these options to:
We introduced this risk in the foreign investments chapter. If you want a quick refresher, here’s a video on currency exchange risk:
Let’s start with an example of a foreign currency option quote:
1 long Euro Sep 1.15 put @ 4
This long put gives the investor the right to sell 10,000 euros at $1.15 per euro.
Equity options use a multiple of 100 shares per contract. Most foreign currency options use a multiple of 10,000 units of the currency.
The main exception is the Japanese yen:
This multiple matters because it determines how much each $0.01 move is worth.
The yen uses a larger unit size because each yen is worth relatively little compared with the U.S. Dollar. For context, ¥10,000 equals about $67 at the time of this writing.
In most cases, you won’t need the 1,000,000-unit yen multiple unless a question asks directly about contract size.
1 long Euro Sep 1.15 put @ 4
In this quote, the investor is bearish on the euro. They’re betting the euro will decline below $1.15 per euro.
Foreign currency option premiums are quoted in cents, even though you’ll often see them written like a typical option premium.
So the total premium paid is:
This is a minor detail for most exam questions. You’ll usually get the premium math right by treating it like a standard option premium (4 = $400).
Hedging against currency exchange risk is a common use of foreign currency options. If you’ve ever exchanged money for an international trip, you’ve seen how exchange rates can change what something costs in dollars.
The U.K.'s currency is the British pound. A few months before your trip, you see the pound is trading at $1.30 per pound. That means converting U.S. Dollars to pounds costs $1.30 for each £1.
Assume you expect to spend £10,000 while you’re there. At the current exchange rate, how much is that in U.S. Dollars?
£10,000 x $1.30 per pound = $13,000
£10,000 = $13,000
So a £10,000 trip costs $13,000 at $1.30/£.
Now suppose that just before your trip, the pound strengthens to $1.50 per pound:
£10,000 x $1.50 per pound = $15,000
£10,000 = $15,000
You’re still spending £10,000, but it now costs $15,000. The pound strengthening increased the cost by $2,000. That’s currency exchange risk.
If you want protection against the pound strengthening (rising), you’d hedge with a long British pound call. Like we covered in the hedging strategies chapter, hedgers typically use long options.
Long 1 Dec British Pound 1.30 call @ 3
For a $300 premium, this call gains intrinsic value if the pound rises above $1.30, helping offset the higher dollar cost of your trip.
Using this example, here are the typical option questions:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at $1.50
If the British pound rises above $1.30, the call gains intrinsic value. The higher the pound goes, the more intrinsic value the call has.
Like other non-equity options, foreign currency options are cash-settled: upon exercise, the writer pays the holder the in-the-money amount in cash.
A premium of 3 means $300 total. Since premiums are quoted in cents, that’s:
If the pound stays at or below $1.30, the call expires worthless and the investor loses the premium.
Breakeven for a call is still strike price plus premium:
At $1.33, the call has $0.03 of intrinsic value, which equals $300 ($0.03 × 10,000), offsetting the $300 premium.
At $1.50, the call is in the money by $0.20:
Subtract the $300 premium paid:
In the trip example, the pound strengthening from $1.30 to $1.50 increased your cost by $2,000. The long British pound 1.30 call offsets most of that increase (by $1,700), leaving a net cost equal to the premium paid ($300).
For math-based foreign currency option questions, treat the contract like a standard option whenever you can. The main differences are the contract size (multiple) and the fact that premiums are quoted in cents.
Currency options aren’t available for every currency. In particular, there is no U.S. Dollar currency option because these contracts are denominated in U.S. Dollars. $1 U.S. Dollar is always equal to $1 U.S. Dollar, so a “U.S. Dollar option” wouldn’t be useful.
This idea shows up in questions 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 eliminate A and C.
The exporter will receive yen and later convert yen into dollars. The risk is that the yen weakens versus the dollar (equivalently, the dollar strengthens). If the yen weakens, converting yen into dollars produces fewer dollars, reducing the exporter’s profit.
To hedge a weakening yen, the exporter wants an option that profits when the yen declines. A long put is bearish and gains intrinsic value when the underlying declines.
Another way to frame it: the exporter will need to sell yen to get dollars. A long yen put gives the right to sell yen at a fixed price, which matches the exporter’s exposure.
Other than the contract multiples (units per contract) and premiums quoted in cents, foreign currency options work like other options, including these characteristics:
Expiration
Settlement
Market sentiment
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