Hedging Instrument - Option & Its Basics

In the previous posting we have discussed one derivative product, Forward Contracts. Here we shall discuss another derivative product called Options. Options have not been designed as a substitute for forward or future, but as a new, distinct financial vehicle that offers significant opportunities and advantages to those seeking either protection or profit from changes in the value of underlying assets. English dictionary gives the meaning of options as “the power of right for choosing between two or more alternatives; an act of choosing”. From the above definition we can say, “Option provides a right but not an obligation”

This chapter we will discuss in details about the foreign currency options. The chapter is divided into 3 parts

1.Introduction to options
2.Definition of options
3.Terminology in the option market
Introduction to options :
The currency options provide the hedger with an advantage which is not available under forward contract. If an Indian exporter has taken a forward contract to sell USD at 43.85 he will receive only 43.85 irrespective of whether Rupee is at 43.50 or 44.15. It will be an advantage if the exporter can get 43.85 when the rate is 43.50 and 44.15 when the rate is 44.15. It is this advantage which is available to a hedger when he uses an option contract.

Definition of Currency Option : A currency option can be defined as a contract which provides to the buyer “right but not the obligation, to buy or sell a specific currency at a specific price(strike price)

Terminology in the Option Market:

Call Option : A call option is an option to buy a currency. Thus the buyer of a currency call option has the right to buy

Put Option : The buyer of currency put option has the right to sell a currency

American Style Option : The holder of an American style option has the right to exercise option any time until the expiry of the option any time until the expiry of the option

European Style Option : The buyer of a European style option has right to exercise the option only on the expiry date.

Strike Rate : Also called the exercise price, it is the exchange rate at which an option buyer has right to but from or sell to the option writer

At the Money : When the strike price of a call is equal to the spot price of the underlying currency, the option is said to be at-the-money

In the Money : When the strike price of a call is lower than the spot price of the underlying currency, the option is said to be in-the-money. An in-the-money call gives the right to buy a currency at a price lower than the spot price, so that exercising the option would give gains.

Out-of-the-money : When the strike of a call is higher than the spot price of the underlying currency, the option is said to out-of-the-money. A put is out-of-the-money when the spot is greater than the strike price.