A currency option is a contract specifying the right to buy or sell foreign exchange (Philadelphia options) or foreign exchange futures (Chicago options) within a specified period. However, this only involves a right, not the obligation. This means that commercial users of the market are able to obtain insurance against an adverse movement in the exchange rate while still retaining the opportunity to benefit from a favourable exchange movement.

Although the contract has an expiry date, the option may be exercised before the maturity date, this kind of options called an American option but if an option can only be exercised on the expiry date it is called European option.There are four ways to trade an option: buy a call, sell (write) a call, buy a put or sell (write) a put.

The owner of the currency option can buy or sell a given amount of one currency for another currency at a fixed price which called exercise price or the strike price. The buyer of the option pays the seller, or writer, a certain sum called the premium, for the right to buy or sell at the prescribed price.

Although options and forwards serve different purposes a comparison between these two instruments may be useful to understand options better. The following figure shows the profit profile of the holder and seller of a call or put option differs from the profit picture of conventional forward contract at expiration.

Source: Giddy (1992)

Giddy (1992) argues the diagrams as follows:

First, the diagrams show the following situations; 1. buy sterling forward, 2. sell sterling forward, 3. buy a sterling call option, 4. buy a sterling put option, 5. sell a sterling call option, 6. sell a sterling put option. In a forward contract, diagram 1 and diagram 2 show, the long or short position produces a one-to-one gain or loss depending on whether the spot rate ends up relative to the contracted forward rate. In an option contract, the gain or loss is asymmetric. Therefore, diagram 3 shows that a call option on sterling. In the diagram, the loss is limited to the price originally paid for the option, plus interest foregone. As long as the spot rate exceeds the prearranged exercise price, some gain will be made. However, the next profit will be positive only when the holder of the call has recouped the price of the option, plus interest. The holder of a put option will gain one-for-one only when sterling has fallen below the exercise price by more than the price of put, plus interest. Again, downside loss is limited. The seller of puts or calls has a profit picture that is the upside-down mirror image of the buyer’s; the most he can gain is the option price, plus accumulated interest; but downside loss is unlimited.

On the other side, the bank over-the-counter options are often hedged by the writer bank with exchange traded options. The hedge may be complete or as near as is available on the exchange. The following table shows the differences between exchange trade and over-the-counter.

Source: Briggs (1987)

The aim of the markets is to provide a continuously active and liquid market in put and call options on foreign currencies. Orders to buy and sell options on foreign currencies are transmitted through brokers to the trading floor of the Exchange in the same way as transactions involving shares. However, currency options, like other types of options, are investments not backed with a certificate of any sort.

In order to illustrate the use of currency options as a hedging instrument, we will now look at the Abdullah’s (1987) example. It is assumed that a US importing company has to make a payment of Ff 10 million in a six-month period. The company treasurer decides to fix the cost of imports in dollar from the current rate by buying Ff 10 million in the forward market for delivery in six months. This commits the company to sell a sum of dollars to a bank at a rate that is in effect at the time of the hedge.

By buying enough French franc call options with the desired maturity, the US firm makes no such commitment. If the franc rises above the strike price specified in the option contract, the company will find it advantageous to exercise the option, using the proceeds to make the payment to the French exporter. If the franc fails to reach the present strike price, the company can allow the option to lapse, in that case it will lose only the premium money paid for the option. To make settlement in francs, the treasurer will take advantage of lower prices in the spot market. The currency option thus allows the importer, in return for a known maximum cost (the premium), to protect the firm against a rising franc, while allowing it to cash in on a falling currency.

A carefully constructed option package can be a very effective hedging instrument. The present high cost of currency options create some restraints to their use, but as the market develops the price will probably drop. There are also ways of buying options and reduce the cost. Option strategies are one way of doing this. A strategy is a sequence of separate options which fit together to produce an overall result. If this sequence includes purchases and sales of options, then the cost will be net cost of purchases less sales.