Foreign Currency Options Trading

Foreign currency options trading serves two purposes for two groups of traders. Companies doing business internationally commonly make or receive payment in currencies foreign to their own. Thus they must trade foreign currencies and they engage in Forex options trading in order to reduce currency risk. Currency speculators seek to take advantage of changes in currency value and may trade currencies directly or hedge risk and gain investment leverage by means of foreign currency options trading. Foreign currencies are traded one versus another. Thus it is not the value of the US dollar or Yen versus gold or commodities that one is concerned with in foreign currency options trading. It is the relative value of the dollar versus the Yen.

Fix Hedge Currency Risk with Futures

Here is a quick example. A Japanese airline wishes to buy a Boeing 787 Dreamliner. Payment will be made in US dollars. Plane will cost around $200 million. Every one percent change in the value of the Yen versus the dollar will change the cost of the delivered airline by $2 million. In the last few months the USD YEN currency pair has varied by 5% from high to low. That would translate to a difference of $10 million in what the Japanese airline might have to pay to Boeing. There are a couple of ways that the Japanese airline might use to reduce currency risk. The first is to buy currency futures. The airline will pick a futures contract that will come due around the time that the airplane will be delivered. They will not need to spend any money with the futures contract but will obligate themselves to purchase dollars for YEN at the contract price on the settlement date. This strategy fixes their cost of doing business as of the expiration dates of their futures contracts but has its drawbacks. Rather the company will buy options and on the options expiration dates will only need to execute the contracts involved if doing so is profitable.

Hedge Currency Risk with Foreign Currency Options Trading

The better alternative in this situation is to buy calls or puts on the USD with the YEN. When to buy calls is when the trader believes that the USD will go up in value versus the YEN by the time that payment is due. When to buy puts is when the trader believes that the USD will fall in value by the time in that payment is due. If the dollar does, in fact, go up in value the trader executes the options contract and buys dollars at the strike price of the contract, the original value of the dollar versus the Yen. As the figures noted above demonstrate, a savings of $10 million on this sort of contract is possible. The trader would only buy puts in this instance if his company already has money set aside in dollars to pay for the plane. If the dollar plummets in value the trader who has purchased puts on the dollar with the Yen can simply exit his contract and take the profit. Thus he will have the same benefit is if he had kept Yen and converted at the time of payment. Speculators can use all of the same techniques but do so in seeking profit in whichever currency pair they are trading.

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