Quick Answer
Foreign currency options hedge exchange rate risk for exporters, importers, and holders of foreign securities. An investor who will receive foreign currency buys puts; one who must pay in foreign currency buys calls. Standardized contracts are typically physically settled (delivery of the actual currency) at 10,000 units (1,000,000 for Japanese yen), though some series are cash-settled.
Moving beyond stocks and indexes, options can also hedge against a different type of risk: currency exchange rate risk. The logic follows a simple rule once you learn it, and it recurs constantly on exam scenario questions.
What Are the Basics of a Foreign Currency Option?
- Foreign currency options are used to hedge currency exchange rate risk by corporations with international operations, importers, exporters, and investors with foreign holdings
- Contract sizes are standardized:
- Most currencies: 10,000 units of the foreign currency per contract
- Japanese yen: 1,000,000 units per contract (because yen are worth much less per unit)
- Foreign currency option settlement is contract-dependent: standardized contracts are typically physically settled (exercise results in delivery of the actual foreign currency), but some series are cash-settled in U.S. dollars instead
- For a cash-settled currency option, the payoff = (exercise settlement value - strike price) x the contract's underlying-currency amount, the same exchange-rate-difference logic as physical settlement, just paid in dollars instead of delivered currency
- Listed on exchanges (primarily the Philadelphia Stock Exchange, now Nasdaq PHLX)
Exam Tip: Gotchas
- The standard convention for foreign currency options is physical settlement (actual currency delivery), which is the opposite of cash-settled index and yield-based options. Some currency option series are cash-settled instead; check what the question describes rather than assuming.
- Japanese yen contracts are 1,000,000 units, not 10,000.
- Example: A cash-settled euro call has a $1.2500 strike. At settlement the euro is worth $1.2607 and the contract covers 10,000 euros. Cash settlement = ($1.2607 - $1.2500) x 10,000 = $107.
What Is the Core Currency-Hedging Rule?
The key to currency options is one simple question: Will you need to BUY or SELL the foreign currency?
| Scenario | Hedge | Rationale |
|---|---|---|
| U.S. exporter expecting to receive foreign currency | Buy puts on the foreign currency | Protects against the foreign currency weakening (falling in dollar terms) |
| U.S. importer needing to pay in foreign currency | Buy calls on the foreign currency | Protects against the foreign currency strengthening (rising in dollar terms) |
| U.S. investor holding foreign securities | Buy puts on the foreign currency | Protects against the foreign currency depreciating relative to the dollar |
Memory Aid: Receive = puts, pay = calls
- If you are going to receive foreign currency (and convert to dollars), buy puts: you want the right to sell the currency at a known rate
- If you need to pay in foreign currency (and must buy it with dollars), buy calls: you want the right to buy the currency at a known rate
Exam Tip: Gotchas
- An investor holding foreign securities has the same exposure as an exporter (will receive foreign currency when selling). Hedge with puts.
What Is the Full-vs-Partial Hedge Distinction for Currency Options?
- Buying an option provides a full hedge (maximum protection) at the cost of the premium
- Selling an option provides only partial protection equal to the premium received
| Action | Hedge Type | Cost |
|---|---|---|
| Buy currency put (exporter) | Full hedge | Pay premium |
| Sell currency call (exporter) | Partial hedge | Receive premium |
| Buy currency call (importer) | Full hedge | Pay premium |
| Sell currency put (importer) | Partial hedge | Receive premium |
Think of it this way: Buying an option is like buying insurance: you pay a premium upfront, but you are fully protected if the exchange rate moves against you. Selling an option is like collecting an insurance premium: you pocket cash now, but your protection only covers a small amount (the premium received).
Exam Tip: Gotchas
- Selling currency options provides only partial protection equal to the premium received. Only buying provides a full hedge.
What Do Currency-Hedging Scenarios Look Like on the Exam?
Scenario 1: U.S. Exporter
A U.S. company will receive 500,000 euros in 90 days. If the euro weakens against the dollar, the dollars received will be less than expected.
- Hedge: Buy 50 euro put contracts (50 x 10,000 = 500,000 euros)
- If the euro falls, the puts gain value, offsetting the currency loss
- If the euro rises, the puts expire worthless, and the company benefits from the stronger euro (minus the premium paid)
Scenario 2: U.S. Importer
A U.S. company must pay 200,000 British pounds in 60 days. If the pound strengthens, the cost in dollars increases.
- Hedge: Buy 20 pound call contracts (20 x 10,000 = 200,000 pounds)
- If the pound rises, the calls gain value, offsetting the higher cost
- If the pound falls, the calls expire worthless, and the company benefits from cheaper pounds
Exam Tip: Gotchas
- When a currency option expires worthless, that is the best-case scenario for the hedger (the currency moved in their favor). The premium paid is the cost of protection, similar to an insurance policy you never needed to use.
- To calculate the number of contracts needed, divide the total currency exposure by the contract size (10,000 for most currencies, 1,000,000 for yen).
What Should You Check on Exam Day?
- Can you apply "receive = puts, pay = calls" instantly to an exporter, importer, or foreign-securities holder scenario?
- Do you remember that foreign currency options are typically physically settled, unlike the cash-settled index and yield-based options elsewhere in this unit, but that cash-settled currency series also exist?
- Can you calculate the number of contracts needed from a total currency exposure and the 10,000-unit (or 1,000,000-unit yen) contract size?
- Do you know buying is always the full hedge and selling is always the partial hedge, exactly as with equity options?