Call option and Put Option
A contract under which the option buyer has the right to purchase the specific currency is the call option. A contract conferring the right to the buyer to sell the specified currency is the put option. Generally the US Dollar is the base currency and the other currency of the contract is the foreign currency that is being bought or sold. For instance in a dollar/yen call option, the buyer acquires the right buy yen against dollar. Similarly, in a dollar/mark put option, the buyer acquires the right to sell mark against dollar.
The consideration for the seller to offer the right to the buyer is the premium. Thus premium is the fee payable by the buyer of the option to the seller at the time of entering into the contract. The premium paid is not refundable whether the buyer ultimately exercises his right or not.
The exchange rate which the currency are agreed to be exchanged under the option contract is strike price. The market price for option is not a single price. Varying prices maybe quoted each at a different premium. The premium charged would vary according to the market perception about the future exchange rate for the currency.
Types of Instruments:
Three types of options are available. These are:
1. OTC options
2. Exchange Traded Options
3. Options on Futures
Over the counter (OTC) options are available with individual banks. They are tailor made to the requirements of the buyer with regard to the maturity, price and size of the contract. The buyer of the option bears the counterparty risk, i.e. the risk that the seller of the option, the bank may fail to fulfill its obligation under the contract. Normally this type of option is confined to contract of large volumes and between big players. Since this is non-standard variety the premium charged may also be higher.
Exchange traded options are physical currency options traded at an organized exchange. That is similar to the OTC option; the buyer acquires the right to buy or sell the foreign currency but for standard maturities and in standard amounts. Thus it is akin to futures contracts and traded on the exchange. The contract is with the clearing house of the exchange and hence the counterparty risk is minimized.
Options on futures give the buyer of the option the right to buy/sell specific number of futures on specified exchange. Depending upon the strike price prevailing the buyer may exercise his option or forgo it. If the buyer of a call option exercises his option, he will receive a long future contract in the currency. That is, he will become the buyer of the future contract in the exchange. Then the future contract will be subject to other regulations like margin, marking to market, etc.
Execution of Contracts: Whether the buyer will exercise his right under the option contract depends upon the spot rate for the currency prevailing on the due date of the contract. Based on the prevailing spot price, the option contract may be considered
(a) In the money
(b) Out of the money, or
(c) At the money.
In-the-money Options:
An Option is in-the-money when it would be advantageous for the holder of the option to exercise his right. Thus, a call option is in-the-money if on the maturely date the spot price for the currency being bought is higher than the strike price under the option contract. For instance, let us say that strike price under the contract is US$0.65 per mark and in the market spot price for mark is US$0.67. It would be advantageous for the buyer of the option to exercise his option and obtain marks at US$0.65 and thereby save US$0.02 per mark.
An put option, on the other hand, is in-the-market, if at maturity the spot price for the underlying currency is cheaper than the strike price under the contract. The difference between the option price and the spot price at maturity, which is in favor of the buyer is known as the intrinsic value of the option.
Out-of-the-money Options:
An option is out-of-the-money, if it is not advantageous for the buyer to exercise his right. A call option is out-of-the market if the spot price for the currency bought under option is lower than the strike price agreed under the contract. A put option is out-of-the money on the maturity date, where the spot price for the currency sold is higher than the strike price under the option contract. When the option is out of the money, the buyer does not exercise his right and the seller stands to gain by the premium he received under the contract.
At the money Options: An option contract is at the money when the strike price is equal to spot rate for the currency concerned on the due date of the contract. It makes no deference to either of the parties whether the buyer exercises his option or not.
