Definition of Currency Put Options
A currency put option grants the buyer the right, but not the responsibility, to sell a set quantity of a currency at a predetermined exchange rate, known as the strike price, within a given time period. The buyer of the put option pays a premium to the seller, who agrees to buy the currency if the buyer exercises the option.
More Thorough Understanding of the Term
The owner of a Currency put option receives the right to sell a currency at a specified price within a specified period of time. As with currency call options, the owner of a put option is not obligated to exercise the option. Therefore, the maximum potential loss to the owner of the put option is the price paid for the option contract.
A currency put option is said to be in the money when the present exchange rate is less than the strike price, at the money when the present exchange rate equals the strike price, and out of the money when the present exchange rate exceeds the strike price. For a given currency and expiration date, an in-the-money put option will require a higher premium than options that are at the money or out of the money.
Currency put options function in the same way as other types of put options. The buyer pays the seller a premium for the opportunity to sell a currency at a fixed price within a set time frame. If the buyer agrees to exercise the option, the seller is obligated to purchase the currency.
A currency put option's pricing is determined by various factors, including the exchange rate, the strike price, the period until expiration, and the volatility of the currency pair. Higher volatility generally leads to higher option prices because there is a greater likelihood that the exchange rate will move in the buyer's favor.
Practical Example
Assume an American company has a six-month contract to pay a European supplier €1 million. The current exchange rate for one euro is $1.20. The American corporation is anxious that the euro may strengthen against the dollar, increasing the cost of the payment.
To mitigate this risk, the American firm can purchase a currency put option on the euro with a strike price of $1.20 per euro and a six-month expiration date. If the euro rises in value, the American firm can exercise the put option and sell the euros at the strike price of $1.20 per euro, limiting its losses.
In Sentences
- Currency put options are a type of financial derivative that allows investors to hedge against fluctuations in exchange rates.
- Currency put options are adaptable instruments that may be adjusted to meet the needs of individual investors.