FX Options are not just graphs and numbers on a city trader's computer screen, but are serious financial tools used widely by businesses to exchange significant and critical sums of foreign currency. We introduce here, the benefits of FX Options in foreign exchange for your business. Take the scenario where a UK importer has a large business deal, and it is necessary to pay their US supplier $500,000 Dollars in 6 months time. They will need to convert British Pounds to Dollars, and can do this in a number of ways: 1) exchange currency in 6 months time 2) agree to a fixed rate contract 3) agree to an FX Options contract Solution 1. The importer approaches their currency broker at the time the US dollars is required, who offers them an exchange rate near the market price. For a deal of this size, this can be considered as reckless. If it was the year 2008 where the GBP/USD rate fell from 2.0 to 1.35 in a space of 6 months, the extra cost to the business would be £120,000 more. Solution 2. The importer agrees to a contract with their currency broker to buy USD in 6 months, at an agreed and fixed rate. In the case for GBP/USD rate worsens in 6 months time, the business will be congratulate itself for an excellent decision. However the contract is binding, and if GBP/USD rate was to improve, then the opportunity to benefit from market improvements are lost. Solution 3. The importer purchases an FX Option from their currency broker. On purchase the importer agree with their currency broker an exchange rate. So for example they agree a GBP/USD rate of 1.5. If in 6 months time, GBP/USD falls to 1.4, then the importer exchange at the better agreed rate 1.5. If the market improves, and GBP/USD increase above 1.5, the importer is not bound to the 1.5 agreed rate, they can trade at the improved market rate as they please. This is an FX Option Here is another example. A business needs to exchange £100,000 British Pounds for Euros in a years time. They agree on an exchange rate GBP/EUR at 1.37, equating £100,000 to 137,000 Euros. On expiry of the Option, 1 year later, here are the possible scenarios. a) The GBP/EUR world market rate falls to 1.25. £100,000 is equivalent to 125,000 EUR. This is 12,000 EUR less than the agreed rate. The business opts to convert at the agreed rate of 1.37 b) THE GBP/EUR exchange rate rises to 1.55. £100,000 is equivalent to 155,000 EUR. The business has the option not to trade at the contract rate, and exchanges his GBP to EUR at the better market rate. They gain 22,000 EUR more than the contract rate. Whats the catch? For the privilege of protecting yourself from market fluctuations with the added benefit of cashing in on market improvements, a fee must be paid. The fee depends on many factors, including the market price, time scale and volatility, so it can only be stated at the time the FX Option is agreed. The cost of purchasing an option can be likened to buying an insurance policy. For important matters where loses are too damaging, like an insurance policy, the benefits far out weigh the costs. However, not all options require a fee. There are actually a number of different types of FX options. Depending on your circumstances and market conditions, a number of options may be suitable. Some FX Options Types Vanilla The vanilla option, has been described and used as examples above. The vanilla options protect against poor exchange rates by setting a protection exchange rate, at the same time giving the buyer an option to exchange at the better exchange rate if it improves. The buyer must pay a fee for the option. Collar Similar to the vanilla option, the buyer is protected by the protection exchange rate. At the end of the contract, if the exchange rate improves, the buyer benefits by trading at the better rate. However the benefit they can hope to achieve is capped by a participating exchange rate. There is no fee for this option. Example: An importer wishes to purchase $100,000 USD in 9 months time. It is expected that Dollar will strengthen in 9 months time frame, so the importer wishes to purchase an option now and set a protection exchange rate. Trade: Exchange GBP to USD Time: 9 Months Amount: $100,000 USD Protection Rate: GBP/USD = 1.45 Participating Rate: GBP/USD = 1.55 Scenario A. At the end of the contract the exchange rate falls to 1.40. The exchange rate falls below the protection rate (1.45) and therefore the buyer decides to exchange at the better protection rate. Scenario B. The exchange rate improves to 1.50 which is better than the protection rate and lower than the participating rate. The buyer takes the option to exchange at 1.50. Scenario C. The exchange rate improves to 1.60. The buyer is capped at the participating rate, and they buy USD at 1.55 Leveraged Collar Similar to the collar option, the buyer is protected by the protection exchange rate. At the end of the contract, if the exchange rate improves, the buyer benefits by trading at the better rate. If the exchange rate rises above the protection rate, the buyer can trade at the better exchange rate up to the level of the participating rate. If the exchange rate improves above the participating rate, the buyer agrees to trade a multiple of the agreed amount, at the better exchange rate. There is no fee for this option. Note that the protection rate and/or the participating rate is slightly higher than the collar option, because the the buyer agrees to a leveraged purchase amount when the exchange rate improves above the participating rate. Example: An importer wishes to purchase $100,000 USD in 9 months time. Trade: Exchange GBP to USD Time: 9 Months Amount: $100,000 USD Protection Rate: GBP/USD = 1.48 Participating Rate: GBP/USD = 1.58 Multiple Agreed: x2 Scenario A. At the end of the contract the exchange rate falls to 1.40. The exchange rate falls below the protection rate (1.48) and therefore the buyer decides to exchange at the better protection rate. Scenario B. The exchange rate improves to 1.50 which is better than the protection rate and lower than the participating rate. The buyer takes the option to exchange at 1.50. Scenario C. The exchange rate improves to 1.60. which is above the participating rate, the buyer must agree to buy $200,000 at the better exchange rate 1.60 Participating Forward Similar to the vanilla option, the buyer is protected by the protection exchange rate. At the end of the contract, if the exchange rate improves, the buyer benefits by trading at the better rate. However the buyer can only trade a portion of the agreed amount at the better rate. The remainder must be traded at the protection rate. There is no fee for this option. Example: An importer wishes to purchase $100,000 USD in 9 months time. It is expected that Dollar will weaken in 9 months time frame, so the importer wishes to purchase an option now and set a protection exchange rate. Trade: Exchange GBP to USD Time: 9 Months Amount: $100,000 USD Protection Rate: GBP/USD = 1.45 Participation Amount: 50% Scenario A. At the end of the contract the exchange rate falls in 1.40. The exchange rate falls below the protection rate (1.45) and therefore the buyer decides to exchange at the better protection rate. Scenario B. The exchange rate improves to 1.50 which is better than the protection rate. The buyer takes the option to buy $50,000 dollars at 1.50 (£33,333) and the other 50% at the protection rate of 1.45 (£34,483). In total it costs them £67,816 to purchase $100,000 Dollars. Participating Collar Similar to the participation forward, the buyer is protected by the protection exchange rate. At the end of the contract, if the exchange rate improves above the protection rate but below the participation rate, the buyer benefits by trading at the better rate. However the buyer can only trade a portion of the agreed amount at the better rate. The remainder must be traded at the protection rate. If the exchange rate improves above the participation rate, the buyer will have to trade a portion of the amount agreed at the protection rate and the remainder at the participation rate. There is no fee for this option. Example: An importer wishes to purchase $100,000 USD in 9 months time. Trade: Exchange GBP to USD Time: 9 Months Amount: $100,000 USD Protection Rate: GBP/USD = 1.45 Participating Rate: GBP/USD = 1.55 Participation Amount: 50% Scenario A. At the end of the contract the exchange rate falls to 1.40. The exchange rate falls below the protection rate (1.45) and therefore the buyer buys $100,000 at the protection rate. Scenario B. The exchange rate improves to 1.50 which is better than the protection rate and lower than the participating rate. The buyer takes the option to buy $50,000 dollars at 1.50 (£33,333) and the other 50% at the protection rate of 1.45 (£34,483). In total it costs them £67,816 to purchase $100,000 Dollars. Scenario C. The exchange rate improves to 1.60. which is above the participating rate, and the buyer must agree to exchange $50,000 at the better protection rate 1.45 (£34,483) and the remaining participation amount at 1.55 (£32,258). In total it costs them £66,741 to purchase $100,000 Dollars. Ratio Forward A ratio forward option offers a protection rate. This protection rate is enhanced and will be better than the other FX Options. If the market exceeds the protection rate at expiry of the contract, the buyer is committed to purchasing a multiple of the contract amount, at the protection rate. There is no fee for this option. An importer wishes to purchase $100,000 USD in 9 months time. Trade: Exchange GBP to USD Time: 9 Months Amount: $100,000 USD Protection Rate: GBP/USD = 1.50 Multiple: x2 Scenario A. At the end of the contract the exchange rate falls to 1.45. The exchange rate falls below the protection rate (1.50) and therefore the buyer decides to exchange at the better protection rate. Scenario B. The exchange rate improves to 1.55 which is better than the protection rate. The importer must buy $200,000 dollars at an exchange rate of 1.50