Global Finance 365Currency Option Contracts
A common feature of option contracts is that they provide the right, but not the
obligation, to either acquire or to sell the contracted items at an agreed price.
The agreed price is called the strike price.In addition, options are considered to
bein the money orout of the money based upon the relationship between the
strike price and the current price. The prices in the case of currency options are
currency exchange rates. For example, a currency option contract is out of the
money if the option provides the right to buy the Irish Punt at $1.12 when its
spot price is $1.10. Conversely, an option is in the money if it provides the right
to sell the German Mark at $0.45 when its spot value is $0.43.
An option contract that gives the holder the right to sell a currency at an
agreed rate, the strike price, is called a put option.The contract that provides
the right to purchase the currency at an agreed rate is termed a call option.
The cost of acquiring an option is termed the option premium. The option pre-
mium is a function of a number of variables. These include the strike price,
the spot value of the currency, the time remaining to expiration of the option
and the volatility of currency and interest-rate levels. Option values are
estimated using methodologies such as the widely used Black-Scholes option-
pr icing model.
Options Contrasted with Forwards Options are frequently characterized as
one-sided arrangements. Consider the case of a firm that wishes to hedge ex-
posure resulting from an Euro account receivable. The Euro amount of the re-
ceivable is E62,500. Because the firm wishes to protect the dollar value of an
asset position (exposure) in the Euro, it would invest in a Euro put option, with
a maturity that is consistent with the collection date for the receivable. A sin-
gle exchange-traded option is acquired and the option premium is $1,000. The
spot value of the Euro is $0.88, resulting in a dollar valuation for the Euro re-
ceivable of $55,000 ($0.88×62,500=$55,000). The strike price is also $0.88,
meaning that the option contract is at the money, that is, the strike price and
spot value of the currency are the same.^17 We will assume that at the expira-
tion date for the option contract the spot value of the Euro is, alternatively,
$0.84 and $0.92. The effects of these two different outcomes are summarized
in Exhibit 12.6.
Unlike the option contract, a for ward contract does not permit the holder
to decline to fulfill the obligation simply because the hedged currency did not
move in an unfavorabledirection. The for ward contract is a symmetrical
arrangement. If a for ward contract had been used to hedge the Euro exposure
in Exhibit 12.6, then there would be offsetting gains and losses on both the
Euro accounts receivable and on the for ward contract, whether the Euro ap-
preciated or depreciated in value.
One-Sided Nature a Hedge with a Currency Option An option contract is
simply permitted to expire unexercised if an option contract is out of the