Currency risk is part of the operational and financial risk, associated with the risks of adverse movement of exchange rate of one currency relative to another. In comparison to investments in local assets, the fluctuating exchange rates represent an additional risk factor for investors who want to diversify their portfolios internationally. Therefore, the control and management of foreign-exchange risk is an integral part of the management of the business with a view to improve the effectiveness of international investments. One generally accepted method for management of this type of risk is currency options trading. This article is concentrated on Forex options trading as a way to hedge and control currency risk.
The use of currency options for exchange-rate risk management is nowadays widespread in developed economies; it is considered to be a routine part of the business of financial institutions and companies. By its nature, the currency option differs from the other types of options by its economic function; it hedges the exchange-rate risk and the underlying asset is a particular currency or set of currencies.
Currency option is a legal agreement that gives the buyer the right, but not the obligation, to buy or sell the underlying asset (currency) at a strike price on or before a predefined future date when the option expires. In legal essence, the currency options trading are provisional and fixed-term transactions. The transaction is conditional, because it runs only if the buyer desires, and it is fixed-term, because its execution is at some time in the future.
Currency options are traded on regulated markets (where they are standardised) or Over-the Counter (where they are unstandardised ). The contract for currency options trading entitles the holder to buy or sell a specified underlying asset on or before a particular time at the predefined contract price. Currency option is a financial asset like shares or bonds and constitutes a legally binding agreement between two parties with strictly defined terms and conditions. It confers the right, but not the obligation for its owner to buy or sell a specified quantity of one currency in exchange of another at a fixed rate, most commonly known as “exercise price” or “strike price.”
The buyer pays a premium to the seller of the option for the right to buy or sell a predetermined quantity of one currency in exchange to another on or before the expiration date at an agreed-on price.
In general, currency options are used for purposeful modification of the risk characteristics of the portfolio, i.e. risk management. In this particular case, currency option has the nature of insurance. The open positions in foreign currencies can be insured against adverse exchange rate movement through the purchase of put options.
Currency options trading are a widely used investment tool for management and protection against currency risk and an integral part of numerous innovative investment strategies. Forex options trading make future risks negotiable; they lead to removal of uncertainty through the exchange of foreign currency risks, known as hedging.
The investors and financial institutions use derivatives for protection against adverse exchange-rate movements. Forex options trading serve as insurance against undesired price movements, which leads to more reliable forecasts, lower capital requirements, and higher productivity.
Besides, currency options trading provide protection against currency risk with minimum initial investment and consumption of capital at exceptionally high adaptability of the contractual terms and conditions in accordance with the specific needs of investors. Forex options trading also allow investors to deal with future price expectations, purchasing a derivative asset instead of the base security at very low transaction price in comparison with direct investment in the underlying asset. In addition to hedging currency risks, currency options are also appropriate instruments for exchange-rate speculations.