What is Foreign Currency or Foreign Exchange Option?

Foreign Currency Option or Foreign Exchange Option is a derivative financial instrument that gives the right to exchange money denominated in one currency into another currency at a specified rate on a specified date. This right to exchange cannot be considered as an obligation.

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How do you Trade Currency Options?

Retail forex traders can avail 2 primary types of options.

  1. Call or Put Option – When the buyer has the right to purchase a currency pair at a given exchange rate in the future, then it is called the call option. When the buyer has the right to sell a currency pair at a given exchange rate in the future, then it is called the put option.
  2. Single Payment Options Currency Trading (SPOT) – They are easier to set and execute. They have higher premium costs compared to traditional options.

How are Foreign Exchange (FX) Options Priced?

FX options are also called Forex options or currency options. The price of foreign exchange option tries to represent the measure of risk. The price of the currency option can be split into 2 components – intrinsic value and time value. Time value calculation is very complex because many parameters influence the time value. Volatility in the currency and the time left until expiration is the major parameters used in the calculation. Intrinsic value is the amount of money realized by exercising our option, under the assumption that the FX spot rate will be the same as the current rate on the date of expiry.

Are FX options American or European?

The style of FX option lets us know when a currency option can be exercised.

  1. European Style – Only the price is relevant at the expiration date.
  2. American Style – Can exercise any time on or before its expiry, the option is more flexible and more expensive

 

The above details would help candidates preparing for UPSC 2020.

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