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Currency Option Types

Whilst there appears to be an extraordinary and confusing array of currency options the majority of them fall into just a few categories. From these basic building blocks more complex and tailored structures are engineered to meet the hedging needs of end users.
Calls and Puts
Since in every currency transaction one currency is bought and another is sold the same is true of options transactions. A Call option is the right to buy a currency and a Put options the right to sell. If you buy a Call option on one currency you are by definition also buying a Put option on another. By definition each currency option is a Call and a Put on the respective currencies as you cannot do one without the other.
Knock-Out Options
These are like standard options except that they extinguish or cease to exist if the underlying market reaches a pre-determined level during the life of the option. The knockout component generally makes them cheaper than a standard Call or Put.
Knock-in Options
These options are the reverse of knockout options because they don't come into existence until the underlying market reaches a certain pre-determined level, at this time a Call or Put option comes into life and takes on all the usual characteristics.
Average Rate Options
The options have their strikes determined by an averaging process, for example at the end of every month. The profit or loss is determined by the difference between the calculated strike and the underlying market at expiry.
Basket Options
A basket option has all the characteristics of a standard option, except that the strike price is based on the weighted value of the component currencies, calculated in the buyer's base currency. The buyer stipulates the maturity of the option, the foreign currency amounts which make up the basket, and the strike price which is expressed in units of the base currency.
Purpose
A Call option enables an option buyer to set a maximum price (rate) at which to buy a currency against another currency. A Put option enables the buyer to set a minimum price at which to sell a currency against another currency.
Description
A Call option is an agreement between the buyer and the seller of the option whereby the buyer obtains the right but not the obligation to buy an agreed amount of a currency at a pre agreed price (the strike price), on an agreed future date (the value date). The choice of whether to use the option is made on the expiry date, which is 2 business days before the value date. A Put option is in all respect the same except that it confers the right to sell at a pre agreed rate. In return for the option, the buyer pays the seller a premium. For the remainder of this example lets assume we are are referring to a bought EURO Call / GBP Put.
Settlement
Settlement only occurs if it is advantageous for the buyer to exercise the option. If the EURO appreciates beyond the strike price, the buyer of an EURO Call option will exercise the option and buy EURO/sell GBP at the strike price. If the EURO is below the strike price at expiry the buyer will simply let the option lapse.
Typical Uses
A customer wishing to gain protection against an appreciating (strengthening) EURO. Customers who are involved in tenders which contain a foreign currency element can protect themselves against adverse currency movements during the time between lodging a tender and receiving notice of its outcome. Should the tender be unsuccessful the maximum cost of hedging is limited to the amount of the premium.
Example - Current Position
You are an Australian based exporter with a GBP 1,000,000 receipt due in three months time. At that time you will need to purchase EURO. The current three month forward rate for EURO/GBP is GBP 0.6500 (spot rate is also GBP 0.6500).
Market Outlook
You are unsure about the future direction of the EURO against the GBP. You wish to protect yourself against an EURO appreciation but would like to gain from any favorable rate movement.
Suggested Solution
You purchase an EURO call option with a strike price of GBP 0.6500 for a total premium of GBP 15,000. This equates to 1.50 % of the face value of the contract.
Result
If the EURO/GBP exchange rate is above GBP 0.6500 you exercise the option. In this case your elective exchange rate will be equal to the strike price plus the cost of the premium. If the EURO/GBP is below GBP 0.6500 you let the option lapse and buy EURO in the spot market. PurposeKnock-out options have been designed to provide customers with a high level of foreign exchange protection at a lower cost than standard currency options, but without removing a company's ability to profit from favorable currency movements.
Description
A knock-out option provides a customer with protection against adverse currency movements in a similar way to a standard currency option. In addition to the normal option variables, the buyer also selects a knock-out price which is a level at which the option lapses and the buyer is left uncovered. If the knock-out price is reached before the option matures the buyer must then choose between remaining uncovered, dealing in the spot or forward markets or selecting new option protection. If the knock-out price is not reached, the option is settled at expiry in the usual way.

Knockout levels are usually set such that the option lapses when it is out of-the-money, i.e. when the spot price has moved in a direction favorable to the underlying exposure. The appropriate rate may depend upon the customer's currency forecasts or may be related to the relative premium cost of the option. The closer the knock-out level is to the current spot rate the cheaper the option. Generally knock-out levels are set at a point where the user will be happy to initiate spot/forward cover, or at a level just above/below important resistance/support levels.
Typical Use
A company wishing to gain cost-effective protection against unfavorable currency movements and who expects the spot rate will trend without significant correction
Exporter Example
Exposure
You are an Australian based exporter with GBP 10,000,000 in receipts due in three months. At that time you will need to buy EURO. The current spot price is GBP 0.5700. The three month forward rate is GBP 0.5710.
Market View
You are unsure of the future direction of the Euro against the US dollar. You wish to protect yourself against an adverse currency movement but would like to gain from a depreciation in the EURO. You would be happy to deal in the spot market if the spot price reaches 0.5400.
Possible Solution
You purchase a knockout EURO Call option with a GBP 0.5700 strike price and a GBP 0.5400 knock-out price for a premium of GBP 150,000. This equates to 1.50%
of the face value of the contract. In comparison a standard three month EURO Call with a GBP 0.6500 strike price would cost significantly more at 1.80% or GBP 180,000.
Outcome
If the spot price of the EURO should trade at GBP 0.5400 (the knock-out rate) before the option matures, the option automatically lapses leaving you without cover. At this point you can deal in the spot market, cover in the forward market or select new option protection. If the EURO/GBP exchange rate is above GBP 0.5700 and the option is not knocked-out you will exercise the option. In this case your effective exchange will be equal to the strike price less the premium.If the EURO is between 0.5700 and 0.5400 you let the option lapse and buy EURO in the spot market.
Purpose
Knock-in options have been designed to provide customers with potentially more attractive pay-off, when they are looking to sell options as part of a hedging strategy, than they could generate by selling standard options.
Description
A knock-in option is an option that only comes into being when a pre-specified spot level is reached. Once the option comes into existence it has all the characteristics of a standard option and will be settled at expiry in the usual way ie. if it is in-the-money it will be exercised and if it is out-of-the-money it will lapse. If the knock-in level is not reached before the option matures the option will not exist.
Typical Use
Knock-in options are generally used in conjunction will standard options to construct cost-effective hedging strategies.
Exporter Example
Exposure
You are an Australian based exporter with a GBP 10,000,000 receipt due in six months. At that time you will need to buy EURO. The current spot price is GBP 0.5700 and the six month forward price is GBP 0.5710.
Market View
You are unsure of the future direction of the Euro against the US dollar but you expect it to trade in a reasonably narrow range. You wish to protect yourself against an adverse currency movement but would like to gain from a depreciation in the EURO.
Possible Solution
You purchase a standard EURO call with a GBP 0.5700 strike price and sell a knock-in EURO put also with a strike price of GBP 0.5700 and a knock-in level of GBP 0.5400. This is a zero cost strategy.
Outcome
If the EURO/GBP exchange rate is below GBP 0.5700 at expiry, and during the life of the option the market has traded at GBP 0.5400 so that the knock-in option has come into being, then the bank would exercise its option and you would deal at GBP 0.5700.If the EURO/GBP exchange rate is above GBP 0.5700 you would exercise the EURO call option. If the EURO/GBP exchange rate is below GBP 0.5700 at expiry, and has not traded at GBP 0.5400 during the life of the option, then both options lapse and you deal at the market rate. Purpose
An average rate option has been designed to provide protection against movements in the average exchange rate over a given period.
Description
There are two types of Average Rate Options:
Average Spot Rate Option
Average Strike Rate Option
You select price, expiry date and averaging dates. The averaging dates can be as frequent as required and need not to be at regular intervals. Similarly, the averaging amounts do not have to be equal. Funds are not exchanged until the final value date, at which time you receive the difference between the weighted average rate over the given period and the agreed strike price if the option is in the money.
Average Strike Rate Option
You only select the expiry date, averaging dates and amounts. On the expiry date the weighted average rate becomes the strike price of the option. If this average rate/strike price is in the money at maturity, you receive the difference between the average rate/strike price and the spot rate at that time.
Typical Use:
A company, with periodic payments or receivables, wishing to gain, trend protection against unfavorable currency movements. (Average Spot Rate Option).
A company with an invoiced cost for materials based on the average of spot exchange rates over a defined period (Average Spot Rate Option).
A company required to translate profits at average exchange rates on balance dates (Average Strike Rate Option).
Average Strike Rate Option Example
Exposure
You are an Australian company that exports GBP 1 million worth of goods to the US each month. You want to protect your receivables over the next 12 months. The current spot price is 0.5700.
Market View
You are unsure of the future direction of the EURO. You want to protect yourself against adverse currency movements but would like to benefit from any appreciation in the EURO.
Possible Solution
You purchase an EURO call Average Spot Rate Option with a strike of 0.5700 and averaging dates at the end of each month. The agreed source for the average rate is the 11.00am daily exchange rate recorded by the Reserve Bank of Australia on Reuters page HSRA This option will cost 1.85% of the GBP amount.

During the period, on each averaging date, you simply sell the US dollars you receive in the spot market for Euros. By dealing as close to 4 p.m. as possible you can ensure that the average rate you effectively deal at over the year is very close to the average rate used to settle the Average Spot Rate Option.

Outcome
At the end of the period you will have effectively dealt at the average rate for the period.

1. If the average rate for the period is greater than 0.5700 you will exercise your option and your bank will pay you the difference between the average rate and the 0.5700 strike price. The amount you receive will effectively lower your actual dealing rates on average, to 0.5700 (provided the basis risk between the rate source for the averaging process and the rate you actually deal at each month is minimal).

2. If the average rate is below 0.5700 you would allow the option to lapse. In this case you will have benefited from the more advantageous averaging rate over the period in your monthly dealings.
Advantages
Protection from adverse movements in exchange rates coupled with the flexibility to take advantage of favorable movements if they occur. Structures tailored to your requirements as to strike price, averaging dates, expiry date and amount to be averaged at each date.
Cost effective relative to a standard option.
Simplifies exposure management. Changes to payments need not cause changes to the option.
Disadvantages
Premium Payable up-front.
Net settlement occurs only at end and thereby not matching cash flows. Basis risk between settlement rate (a mid point) and actual dealing rate.
Purpose
Basket options have been designed to provide portfolio managers with a cost-effective solution to managing multi-currency exposures on a consolidated basis.
Description
A basket option has all the characteristics of a standard option, except that the strike price is based on the weighted value of the component currencies, calculated in
the buyer's base currency. The buyer stipulates the maturity of the option, the foreign currency amounts which make up the basket, and the strike price which is expressed in units of the base currency.
At expiry, if the total value of the component currencies in the spot market is less favorable than the strike price of the basket option the buyer would let the option lapse. If it is more favorable, the buyer would exercise the option and exchange all of the component currencies for the pre-specified amount of base currency (i.e. the strike price of the option).

A basket option can cost significantly less than multiple single currency options. The lower the correlation between the various currency pairs which make up the basket the greater the cost saving.
Typical Use
A fund manager looking to protect the total value of a basket of currencies against unfavorable currency movements.