FX/Currency options allow a company to protect itself from undesirable exchange rate fluctuations.

If a company buys a currency option, on a specified future date, it is entitled to buy (call) or sell (put) an agreed currency amount at a pre-agreed exchange rate.
A currency option can best be described as an insurance policy providing cover against undesirable exchange rate fluctuations. As with forward-exchange contracts, currency options offer companies a guaranteed rate for exchanging currency at a future date.
In the past, only forward exchange contracts were used to hedge against undesired exchange rate fluctuations, but currency options are now being used to a much greater extent.
The advantage of a currency option compared with a forward transaction is that the company may benefit from any advantageous exchange rate movements during the period up until the maturity date.
On the maturity date, the company can choose between the option’s strike price and the current market rate (spot rate).
The option premium is normally stated as a percentage of the contract amount, and is paid when the transaction has been carried out. The size of the premium is determined by the following factors:
  • Volatility: The premium increases with increased volatility. Volatility is an expression of the market’s current stability. An increase in volatility means greater instability.
  • Term: The premium increases over the term of the option.
  • Strike pric:eThe premium increases the more advantageous the price it is to be possible to buy/sell at on the option’s maturity date, compared with the market price.
  • The underlying currency amount
  • The interest levels of the two underlying currencies
  • The spot rate
The two variables the company itself can choose are term and strike price. The term is often evident from the underlying position to be hedged, while the strike price is something the company can choose in order to affect the option premium. Many will choose a strike price similar to the current spot rate or forward rate. However, it is not uncommon for the strike price to be drastically different, which often reduces the option premium.
 A significant reduction in the option premium can be achieved by choosing a strike price higher than the market rate. provided that the right to purchase the underlying currency value is purchased, and correspondingly by choosing a low strike price when there is a right to sell.