Options

A foreign currency option is a financial instrument that allows the owner of the option the right, but not the obligation to exchange funds from one currency in to another at a pre-agreed exchange rate on a specific date in the future.

Example:

Company Y are anticipating buying some machinery from Israel in 6 months time. If Company Y continues to expand the business it will need the machinery, however if business slows, it wont require the machinery. Company Y is a UK based firm, and would need to convert Sterling to purchase the machinery which costs 1,000,000 NIS. The current exchange rate is 5.80, and based on this rate Company Y can afford to purchase the machinery. However, if the rate were to slip to 5.75 it would become unaffordable.

The solution for Company Y is an Option. Company Y purchases an Option to purchase 1,000,000 NIS for 6 months time at a rate of 5.80. In order to do so Company Y pays a premium. This premium is a fee and is not re fundable. Company Y now knows that IF it needs to buy the machinery in 6 months time it can afford to, as they have guaranteed a rate of at least 5.80.

The reason company Y has guaranteed a rate of at least 5.80 is as follows:

If in 6 months time the exchange rate is 5.40, Company Y will then take up the option of buying the currency at 5.80. If the exchange rate is 6.20 in 6 months time, Company Y does not take up the option of buying at 5.8 and instead buys the 1,000,000 NIS at the rate of 6.2.

By taking the option, Company Y would have saved themselves approximately £12,000 taking in to consideration the cost of the option.

Advantages:

• Helps to protect against volatility in foreign exchange rates.
• Allows the flexibility of taking advantage of upward movements in the exchange rate whilst protecting against downward movements.
• If the currency is not needed, there is no commitment to buying the currency.

Disadvantages:

• The premium can be expensive.
• If the exchange rate increases, the premium paid needs to be considered in any calculations.