What is the Foreign Currency Option?
A foreign currency option is a financial instrument that gives you the right, but not obligation, to exchange one currency for another, on a given date, at a predetermined exchange rate (strike price). Foreign currency option eliminates the spot market risk for future transaction. Currency options do not obligate you to deal if the spot rate is more favorable than your option's strike price. As the name implies, you have an option to deal or not.
There are two types of option contracts; Puts and Calls. Purchasing these contracts give you the right to sell (put) or buy (call) a certain amount of a base currency at a specified strike price at a predetermined date.
For example, USD/GEL Put option lets you sell USD at a prearranged strike price at the time of option maturity. You would purchase this option if you would like to hedge against the fall of US dollar. USD/GEL Call lets you buy USD at a prearranged strike price at the time of option maturity. You would purchase this option if you would like to hedge against the possible appreciation of the USD/GEL exchange rate.
As with any insurance or hedging tool, buying an option involves an upfront cost or “premium.” This is determined by the spot and strike exchange rates, the expiry date, foreign and domestic interest rates and volatility of a currency at time of purchase. The premium is higher for more volatile exchange rate. You pay no other transaction costs or commissions.
If your company exports goods, for example, to the EU, you need to sell EUR and to buy GEL in order to convert your EUR receivables. If GEL rises in value, you will lose money. Purchasing a EUR/GEL Put option can protect you against this unfavorable exchange rate movement, because it lets you know with certainty the highest price you have to pay for GEL purchase. Of course, you can still take advantage of a cheaper GEL at the time of option maturity by buying GEL in the spot market.
If your company imports goods, for example, from the U.S., you will need to sell GEL and buy USD in order to convert your GEL receivables. If the GEL falls in value, you will lose money. Purchasing USD/GEL Call Option can protect you against this unfavorable exchange rate movement, because it lets you know with certainty the highest price you will have to pay for USD purchase. If there is a favorable exchange rate movement, you can still take an advantage of a cheaper USD at the time of option maturity by buying it in the spot market.
Both call and put options protect you from an unfavorable exchange rate movement while allowing you to benefit from a favorable one.