The purchase of an FX option contract provides the client with the right, but not the obligation, to buy a specified amount of an underlying currency at an agreed upon exchange rate (the strike rate) on a specific future date (the expiry date).
In exchange for buying this right the client will pay an upfront fee, known as the option premium, to Square 1 Bank.
The client will choose the currency pair and option maturity as business needs require. The strike price can also be negotiated but is typically designated as either the forward price associated with the option maturity date or the current spot price.
XYZ Company is negotiating a potentially large product sale, GBP 4.0 MM, with a British customer that would close in 90 days (t+90). Exchange rates are currently favorable for remitting GBP back into USD. XYZ Co. wants to be opportunistic with the exchange rate environment if the sale happens by protecting itself from a fall in GBP/USD, but does not want to be obligated to an FX transaction if negotiations fall apart. Also, XYZ Co. would like to maintain upside potential if exchange rates continue to move in its favor.
XYZ Co. will purchase a USD call option (GBP put option) with the following details.
XYZ Co: Buys USD / Sells GBP
Amount: GBP 4.0 MM
Maturity: 90 days
Strike Price: 1.3600
Option Premium: USD 255,000 paid up front to Square 1 Bank
Scenario 1: The sale is agreed with the British customer for a t+90 close. At expiry if:
- GBP/USD < 1.36; XYZ Co. will exercise its right to sell GBP at the strike rate of 1.36. The status of the option is known as In-the-Money (ITM). The option has protected XYZ Co. from a fall in GBP/USD.
- GBP/USD > 1.36; XYZ Co. will forgo is right to sell GBP at the strike rate of 1.36 and execute a spot transaction at the prevailing market rate instead. The status of the option is known as Out-the-Money (OTM). The option allows XYZ Co. to capture the upside of an increase in GBP/USD.
Scenario 2: The sale falls through before maturity date of the option. At expiry if:
- GBP/USD < 1.36; XYZ Co. can exercise its right to sell GBP at the strike rate of 1.36 and immediately buy the GBP back from Square 1 Bank for a profit in a spot transaction at the prevailing market rate. XYZ Co. could also choose to sell the option itself back to Square 1 Bank before the expiry date. The status of the option is known as In-the-Money (ITM).
- GBP/USD > 1.36; XYZ Co. will forgo is right to sell GBP at the strike rate of 1.36 and let the option expire worthless. The status of the option is known as Out-the-Money (OTM).
- With a non-linear payout FX options are useful hedging tools that allow continued upside exposure and provide full protection at expiry from adverse exchange rate movements.
- A Call option is the right to buy one currency; A Put option is the right to sell one currency.
- FX options give the buyer the right to buy one currency and sell another. Therefore all FX options are simultaneously a Call option in one currency and a Put option on another.
To learn more, please contact Stasia Harris , SVP, Treasury Management.