Introduction to the Currency Option Market

Currency options are financial derivative instruments that allow investors to hedge currency or speculate about price changes in a single currency. Investors and traders may also purchase options to convert money in a currency to another at an agreed-upon exchange rate by a certain date. The owner is not obligated to execute an options contract and may allow it to expire at no value.

Function

• The Foreign Exchange (FX) options market provides ready liquidity for currency options on currency anywhere in the world. Many FX options trade over-the-counter (OTC). The Chicago Mercantile Exchange (CME), International Securities Exchange (ISE) and Philadelphia Stock Exchange (PHLX, owned by NASDAQ) provide markets for some currency options. Exchange-traded options provide investors with easily accessible market and price quotations.

Size

• According to the Bank for International Settlements, a portion of this vast market--OTC currency options--had approximately $10 billion in outstanding contracts at year-end 2009. The total market, quoted by BIS, exceeded $100 billion in the same period. Institutional investors, including multinational corporations, use currency options to hedge their investments against price movements in other currencies.

Types

• According to "International Financial Management" (2008), currency call options provide the buyer with the right to buy a stated amount of currency at an agreed-upon strike, or established price, by a certain date. People purchase call options to hedge against a currency rate increase. When an investor believes that the value of the dollar will rise against other currencies, she purchases USD currency calls to lock in the price at which to buy dollars. She also purchases time value in the call option. She may purchase dollars at the agreed-upon rate for a known period. If the dollar rises, the investor exercises the call and makes a profit.

  Currency put options provide the buyer with the ability to sell currency at a certain price for a given period. An investor buys put options on the GBP if he believes the British pound's value will decline against other currencies. He will sell the put option at a profit when the pound's exchange rate drops against other currencies.

Features

• European-style currency options allow investors to exercise a call or put options contract only at expiry. For this reason, European-style options do not fluctuate according to current market prices. European options may cost more than American-style currency options.

  American-style currency options allow investors to exercise their call or put any time up to expiration of the contract. Exchange rates may move quickly. Currency options markets may be volatile as exchange rates move up and down prior to contract expiration.

Warning

• Currency options may move quickly, and 100 percent capital loss is possible. Research currency options carefully before making an investment.