Question

Answer the following questions (100 words minimum each), please include at least one external source to support your answers, answers under the word count minimum and/or without an external source will be downvoted:

1.) What is the purpose of currency option contracts?
2.) How could you hedge transaction currency risk exposure with currency option contracts?

Answer 1

1. Purpose of currency option contracts

An option is a contract that gives its owner the right (but not the obligation) to buy or to sell an underlying asset (for example share, foreign currency, etc) on or before a given date at a fixed price (this fixed price is called exercise price. It is also called as Strike Price)

The main purpose is to Hedging against risks:

  Options are an excellent way of protecting your stocks portfolio or hedging exchange risk. Buying options is actually like buying insurance for your stock portfolio and minimizing your exposure to risk. If the price of the underlying security for a call option does not rise above the strike price when the option expires, your option becomes useless, and you lose all the money you paid up front (Option premium).

2.Hedging  transaction currency risk exposure with currency option contracts

There are various trading strategies used by option traders to hedge their risk,these are explained below:

1.Call option

A call option is a type of options contract which gives the option buyer the right, but not the obligation to buy a security or any financial instrument at a specified price (or the strike price of the option) within a specified time frame. To buy a call option, option buyer needs to pay the price in the form of an option premium to the option writer (option seller).

it is upon the discretion of the option buyer on whether he wants to exercise this option. He can let the option expire if he deems it unprofitable. on the other hand, the option seller, is obliged to sell the securities that the buyer desires. In a call option, the losses are limited to the options premium, while the profits can be unlimited.

2. Put Option

Put options give the option buyer the right to sell an underlying security at a specific strike price within the expiration date. This lets investors (option buyer) lock a minimum price for selling a certain security or currency. Here too the option buyer has no obligation to exercise the right. In case the market price is higher than the strike price, he can sell the security at the market price and not exercise the option. Option premium should be paid to writer.

3.Straddles

The straddle option consists of two options contracts, a call option and a put option. For the straddle option to be used correctly, both the call and the put options have to have the same expiration date and the same strike price.

4.Strangles

  Strangle has similar strategy of straddle except that the strike price in the call and put are different