(d) Currency Options. Many companies, banks, and governments have extensive
experience in the use of forward exchange contracts, whereas currency options—or
option contracts in general— are still used far less frequently. However, as market
participants have developed a better understanding of option pricing, trading, and
hedging of options positions over the last couple of years, the use of options has be-
come more frequent. But when comparing options with forwards and futures, one has
to be aware of the fact that these types or categories of financial instruments have
very different characteristics and hence serve very different purposes.
With a forward contract, one can lock in an exchange rate for the future. There are
a number of circumstances, though, where it may be desirable to have more flexibil-
ity than a forward contract provides. For example, a computer manufacturer in Cali-
fornia may have sales priced in U.S. dollars or in euros in Europe. Depending on the
relative strength of the two currencies, revenues may be realized in either euros or
dollars. In such a situation, the use of forward and futures would be inappropriate:
There is no point in hedging a position that does not exist. What is needed in this sit-
uation is a foreign exchange option that represents the right to exchange currency at
a predetermined rate.
A foreign exchange option is a contract for future delivery of a currency in ex-
change for another, where the holder of the option has the right, but not the obliga-
tion to buy (or sell) the currency at an agreed price, the strike or exercise price. The
right to buy is a call; the right to sell is a put. For such a right the option buyer pays
a price called the option premium. The option seller receives the premium and is
obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his
option. In some option contracts, the instrument being delivered is the currency it-
self; in others, a futures contract on the currency. American options permit the
holder to exercise at any time before the expiration date; European options only on
the expiration date; Asian options have an exercise price that represents an average
rate.
Futures and forwards are contracts in which two parties oblige themselves to ex-
change an asset under specified conditions in the future, which makes them useful to
hedge or to convert known currency or interest rate exposures. An option, in contrast,
offers flexibility in that its holder can decide at any point in time whether he wants
to exercise the option now or later, sell it, or let it expire without exercise. Options
are often compared to insurance because of their asymmetric payoff structure that
“keeps the upside potential while eliminating downside risk.” This view, however,
represents a misconception of the true nature of this type of financial instrument. Op-
tions can be properly used for hedging purposes, that is, for risk reduction, only if the
exposure the firm faces has been an option-type character, too. In the above example,
the computer manufacturer has effectively granted a currency option to his European
customers, giving them the choice to pay in U.S. dollars or euros. Therefore, he can
offset his exposure to unanticipated changes in the exchange rate by an equivalent
currency option.
In the presence of currency exposures, however, for example, caused by foreign
currency receivables or liabilities, the use of options has to be regarded as position
taking, that is, speculating. Although there may be nothing wrong about speculating
per se, it should not, but often is, done under the guise of hedging. Speculating means
taking a position against the market; thus, a person who speculates puts money at risk
under the premise that he or she has superior information than professional market
6 • 26 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK