To understand currency options, you need to understand the scope and subtleties of business on an international scale. Because that’s the fundamental heart and soul of currency options, or contracts that allow one to lock in an exchange rate over a given period of time, even if the actual market moves away from the given amount.
Currency Options as a Hedge Strategy
Let’s say you run a company that sells products to Great Britain. You secure a contract for $1 million dollars, or from your customer’s point of view, at the current exchange rate, 500,000 pounds.
Let’s further say that you get 10 percent paid now, the other $900,000 payable upon delivery, say, six months later. All well and good on paper, but if the exchange rate moves against you, you stand to lose significant money. Because the buyer is in Britain, and because of that the deal will be paid in British pounds at the time of closing.
At the time of your sale, let’s say (for clarity sake) that the exchange rate was 2 to 1 – two American dollars for every pound of British Sterling. You get your deposit of $100,000 paid in British Sterling in the amount of 50,000 pounds, which nets you (not counting small exchanges fees, at least in this example) $100,000 at the 2 US to 1 Pound rate. So far you are dead even.
Now let’s say that the exchange rate moves against you.
What if the exchange rate shifts to a rate of 1.8 to 1? Not good. B Because when the time comes for your British customer to pay up, they’re still going to give you the same 450,000 unpaid balance, paid in British Sterling pounds. But instead of it being worth $900,000, which was the unpaid balance in US funds at the time of the sale six months ago, now, at a 1.8 US to 1 British Pound going rate, that 450,000 pound exchanges into only $810,000.
You’ve just lost $90,000 in revenue. And nobody’s done a thing wrong, nobody’s cheated you. You just got on the wrong side of the exchange rate, and it cost you most of your profit margin.
To prevent that from happening, companies buy contracts – called Forex options, which are nothing other than currency options futures contracts – that lock in a given exchange rate over a specified length of time.
In our example, you would buy enough options to cover 450,000 British pounds at an exchange rate of 1 for 2 US dollars. In effect – though the machinations of this would be more complex in the real world – you’d take your 450,000 British pounds and now exchange it for the full $900,000.
Options as Profit Centers
If the market had gone the other way, the options contract itself would be in the black, allowing you to make even more money. And while you indeed had to invest in that 2 to 1 contract up front, you did so at a time when that was the going rate, which means it cost you much less than the difference in the exchange rate, as it turns out, at the time of the contract’s expiration.
Currency options are available in virtually every active monetary unit on the planet, with active and liquid markets that are, in comparison to listed stock options exchanges, relatively unregulated but nonetheless dependable. Because of the quick availability of data in these markets, and the relatively small denominations available, today’s smaller individual investors are getting into the game, as well.
But whether you’re a large multinational or someone who’s just read an article online, the risks are the same. The exchange rates move on a variety of factors, none of which are within your control or even within your understanding. Which makes this game one best suited not only to the financially sophisticated, but to the strong of stomach, as well.
