Foreign currency options are based on the value of a foreign currency relative to the U.S. dollar. Investors use these options to:
If you want a quick refresher on this type of risk, watch this video:
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 an exchange rate of $1.15 per euro.
Equity options typically cover 100 shares. Most foreign currency options cover 10,000 units of the currency.
The main exception is the Japanese yen:
This “multiple” tells you how many currency units the option controls, which is what determines the dollar value of gains and losses.
The yen uses a larger unit size because one yen is worth relatively little compared with one U.S. dollar. For context, ¥10,000 equals about $67 at the time of this writing.
In most cases, you won’t need to focus on the 1,000,000-unit yen multiple unless a question specifically asks 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 weaken below $1.15 per euro.
Because the contract size is 10,000 units, premiums are quoted in a way that can look unfamiliar at first.
This is a minor detail in most problems. You’ll usually get the premium questions right if you treat it like a typical option premium (premium of 4 = $400).
Hedging currency exchange risk is a common use of foreign currency options. Any time you’ll need to convert currencies in the future, changes in the exchange rate can change your cost (or your proceeds). Let’s walk through a simple example.
The U.K.'s currency is the British pound (GBP). A few months before your trip, you see the pound trading at $1.30 per £1. That means converting U.S. dollars to pounds costs $1.30 for each pound.
Assume you expect to spend £10,000 while you’re in London. At the current exchange rate, how much is that in U.S. dollars?
£10,000 × $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 £1:
£10,000 × $1.50 per pound = $15,000
£10,000 = $15,000
You’re still spending £10,000, but the trip now costs $15,000. The pound strengthening increased your cost by $2,000. That’s currency exchange risk.
If you want protection against the pound strengthening (rising), you’d want a position that benefits when the pound rises. That’s a long British pound call.
Long 1 Dec British Pound 1.30 call @ 3
For a $300 premium, you get the right to benefit if the pound rises above $1.30. If the pound strengthens, the call gains intrinsic value, which can offset the higher 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 option has.
Like other non-equity options, foreign currency options are cash-settled at exercise. The writer must pay the holder the in-the-money amount (intrinsic value) in cash.
A premium of 3 means $300 total. With foreign currency options, the premium is quoted in cents and the contract size is typically 10,000 units:
If the pound stays at or below $1.30, the call expires worthless and the investor loses the premium.
Treat the breakeven calculation the same way you do for equity options, but remember the premium is in cents.
At $1.33, the option 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:
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 $1,700 of that increase, leaving a net cost increase equal to the premium paid ($300).
When you see a math-based foreign currency option question, treat it like an equity option whenever possible. The contract size and premium quoting are different, but the option fundamentals are the same.
Currency options are denominated in U.S. dollars, so there is no U.S. dollar currency option. $1 U.S. dollar is always equal to $1 U.S. dollar, so a “USD option” wouldn’t be meaningful.
This idea shows up in questions like the one below:
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 U.S. dollar (equivalently, the dollar strengthens). If the yen weakens, converting yen into dollars yields fewer dollars, reducing the exporter’s profit.
To hedge against 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 falls.
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 the way premiums are quoted, foreign currency options work like other options, including these characteristics:
Expiration
Settlement
Market sentiment
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