What Is Currency Call Options?
A currency call option is a financial contract that offers the buyer the right, but not the duty, to purchase a certain quantity of a foreign currency at a predetermined exchange rate on or before a certain date. If the buyer agrees to exercise the option, the seller of the option, also known as the writer, is compelled to sell the currency.
Currency call options are a key tool in the financial sector for investors and traders who seek to hedge against anticipated currency changes or bet on future exchange rate movements.
More Thorough Understanding of the Term
A Currency call option grants the right to buy a specific currency at a designated price within a specific period of time. The price at which the owner is allowed to buy that currency is known as the exercise price or strike price, and there are monthly expiration dates for each option.
The buyer pays the seller a premium for the option, which is the contract price. The premium is determined by various factors, including the current exchange rate, the period until expiration, currency volatility, and the strike price.
If the exchange rate on the expiration date is greater than the strike price, the buyer can exercise the option and purchase the currency at the lower strike price, resulting in a profit. If the exchange rate falls below the strike price, the buyer can let the option expire and avoid the potential loss.
Currency options quotations are summarized each day in various financial newspapers. Although currency options typically expire near the middle of the specified month, some of them expire at the end of the specified month and are designated as EOM.
Benefits of Currency Call Options
Currency call options provide numerous advantages to investors and traders.
- They offer a low-cost alternative to hedge against currency risk, which is especially crucial for enterprises with extensive exposure to foreign currencies.
- They provide flexibility in controlling currency risk by allowing buyers to exercise the option only when the exchange rate is advantageous.
- They provide the opportunity for profit if the exchange rate rises in favor of the buyer.
Risk Associated with Currency Call Options
Currency call options have additional risks that investors should be aware of.
- Buyers must pay a premium for the option, which reflects a cost regardless of whether the option is exercised or not.
- To earn, buyers must accurately estimate the direction of the exchange rate movement. If the exchange rate goes against the buyer, they may incur a loss equivalent to the option premium paid.
- Because options have an expiration date, buyers must be correct not only about the direction of the exchange rate but also about the time of the movement.
Practical Example
A US corporation is expecting a €1,000,000 payment from a European customer in three months. They are concerned that the euro would fall in value against the dollar, so they purchase a currency call option for $10,000. The strike price is $1.20/€, implying that they have the option to purchase €1,000,000 at that price.
If the euro strengthens against the dollar and the exchange rate on the expiration date is $1.25/€, the US company can exercise the option and buy €1,000,000 at the lower strike price of $1.20/€, then sell the euros in the spot market at the higher rate of $1.25/€, earning $50,000 ($1.25/€ - $1.20/€ x €1,000,000). However, if the euro falls in value against the dollar and the exchange rate on the expiration date is $1.15/€, the US company can let the option expire and avoid a $50,000 loss ($1.20/€ - $1.15/€ x €1,000,000).
In Sentences
- Currency call options can help investors and traders hedge against currency risk or speculate on exchange rate movements.
- Before investing in currency call options, buyers should carefully consider the potential benefits and risks.