Currency options are more flexible as it provides perfect hedge without binding organization, as currency futures (future contract) and forward contract binds the organization.
Currency option provides the right without binding the holder to exercise at specific price (exercise price) until expiry date. After expiry date, option is lapse it means cannot be exercised afterwards. However, option may be exercised before the expiry date.
Cost of option is the amount of premium paid at the time of entering into option. Premium is not refundable in any case. Cost of premium can be substantial such as 10% of the amount of foreign currency to be hedged.
US option gives the right to the holder to exercise it anywhere from issue date to expiry date. UK option gives the right to the holder to exercise only at expiry date. Therefore, in practice, US option is more popular than UK option; therefore, we will assume US option in the following discussion.
Holder of the option will exercise if it results in gain (option is in the money) and will not exercise if it results in loss (option is out of the money).
If organization is required to pay foreign supplier, then it should enter into call (right to buy foreign currency in future) option. If organization is expecting to receive money from foreign customer, then it should enter into put (right to sell foreign currency in future) option.
Holder of the call option will exercise if exercise price is lower than foreign exchange rate at exercise date. Organization will benefit by purchasing at lower rate (exercise price) than it would buy at foreign exchange rate in the market. If exercise price is higher than foreign exchange rate, then organization is free to allow it to lapse.
Holder of the put option will exercise if exercise price is higher than foreign exchange rate at exercise date. Organization will benefit by selling at higher rate (exercise price) than it would sell at foreign exchange rate in the market. If exercise price is lower than foreign exchange rate, then organization is free to allow it to lapse.
Option can be purchased from bank if over the counter (OTC) or tailor made option is desired.
Option can also be purchased from option exchange if standard option is available. Standard option is only available in limited foreign currencies. Standard options can be sold in the option exchange just as ordinary shares can be sold in stock exchange.
Organization, that sells (call or put) option is known as option writer. Option writer exposes itself to foreign exchange risk in return for premium, which represents profit to the option writer.
Benefits
Option is useful when outcome of the future transaction is not known.
When preparing pricing lists for goods or services.
In case, managers are risk averse. Managers may want to protect organization against both foreign exchange risk and losses due to application of wrong hedging techniques.
Limitations
Cost of premium can be substantial.
Payment is required in advanced.
Tailor made option cannot be sold in option exchange.
Standard options are not available in every foreign currency.
