What Are Currency Options?
Owners of import and export business have to take the proper measures to make sure that everything from when the item is shipped until it is received is done perfectly. One of the most important parts to prepare for this is the adverse currency fluctuations in the foreign exchange market. This could end up costing them hundreds to thousands of dollars from the bottom line.
Businesses usually consider using currency options to protect them against these potential losses when dealing with foreign transactions. These options let them decide to sell or buy currency at a specific exchange rate within the set time frame. This may seem like the best option, but business owners need to fully understand how they work before deciding to implement them in their hedging strategies.
How Do These Options Work?
These currency options do give the businesses flexibility of protection from unfavorable exchange rate movements in the global market, but can benefit them when the movements are profitable. Every option has a stock price, rate at which the specific currency can be bought and sold, and they also have an expiration date, the amount of time the business has to buy the currency at the agreed price. “An option is just another tool that companies can use, like a forward, to hedge or protect themselves against any negative risk involved in currency market,” Says Tiffany Burk, senior European market analyst at Western Union Business Solutions.
Forward Contracts require a currency purchase after a specific time period. This is regardless of the exchange rate. Currency options; however, allow an owner to opt out of the contract before the expiration date only if the rate fluctuates in the wrong direction.
Call Options vs. Put Options
A business owner has two options when executing currency option in the global market. These options depend on whether that owner plans to sell or buy the currency.
This first option allows business owners to buy currency at an exchange rate that is predetermined before the expiration date, especially when a business owner thinks the rate will increase, says Douglas Goldstein, CFP, associate director of Portfolio Resources International Group Inc in Miami, president of Profile Investment services, a financial planning firm in Jerusalem, Israel, and author of the The Expatriate’s Guide to Handling Money and Taxes. An example of the would be if a business owner from America wants to buy manufactured items from Germany but thinks the cost of the euro will go up against the U.S. Dollar (USD) within the next few months. They could purchase the call option on the EUR/USD for the needed time frame to benefit from increase in exchange rate of euro against the USD.
The second option gives business owners the ability to sell the currency before the option expires at the predetermined rate. This is usually done because they expect that in the near future the price will drop, Says Goldstein. For example, if a business owner from America wants to sell to a supplier in Spain, who is going to pay for the goods in Euros, and expects the value of the euro to drop when converting back to USD, the owner could put the option on the EUR/USD.
Hinojosa strongly suggest business owners to find an expert on the foreign exchange market to help them learn about which option works best for their business before deciding to use currency options.