What an FX option is
An FX option gives its buyer the right, but not the obligation, to exchange an agreed amount of one currency for another at an agreed rate, the strike, on an agreed date, the expiry. The buyer pays a premium for that right, usually upfront. Every FX option is a call on one currency and a put on the other: a Canadian exporter that will sell US dollars buys a US dollar put, and an importer that will buy US dollars buys a US dollar call.
If the market rate at expiry is worse than the strike, the buyer exercises and exchanges at the strike. If the market rate is better, the buyer lets the option expire and exchanges in the market. An option that expires unused has done its job: it protected the rate in case it was needed. The premium is not refunded.
Exercise terms
When an option can be exercised depends on its contract terms. A European style option can be exercised only at expiry. An American style option can be exercised at any time up to expiry. Most corporate FX options are European style, and the term sheet states which applies. Options are not generally exercisable at any time, and a hedging decision should not assume they are.
An exercised option usually settles by exchanging the two currencies at the strike on the settlement date, so the business needs the currency it is selling on that date, just as with a forward.
Protection and participation
Protection is the worst rate the business can receive on the hedged amount. Participation is how much of a favourable move it keeps. A forward gives full protection and no participation. A vanilla option gives protection at the strike, less the premium, and full participation. Every structure sits somewhere between, and what it offers on one side it pays for on the other.
A vanilla option
A Canadian exporter expects $1,000,000 USD in six months. Spot is 1.3700 and the six month forward rate is 1.3650. Instead of a forward, it buys a six month European style US dollar put with a strike of 1.3500, for a premium of 0.0090 Canadian dollars per US dollar.
- Premium paid upfront$9,000 CAD
- Worst rate after the premium (1.3500 − 0.0090)1.3410
- If USD/CAD is 1.3000 at expiry: exercise at 1.35001.3410 after premium
- If USD/CAD is 1.4000 at expiry: let it expire, sell at 1.40001.3910 after premium
The worst case is 1.3410, below the forward's 1.3650. In exchange, the exporter keeps the benefit of any rise above 1.3500, less the premium. Effective rates here ignore the cost of paying the premium six months early.
Collars, participating forwards and other structures
Most corporate structures combine a bought option, which gives protection, with a sold option, which pays for it. Selling an option creates an obligation, and that obligation is where the cost goes.
Collars
A collar buys protection at one strike and sells participation above another. For an exporter, buying a 1.3400 put and selling a 1.3900 call on the same amount gives a rate of at least 1.3400 and at most 1.3900. When the strikes are chosen so the two premiums offset, it is a zero premium collar. A premium funded collar pays a smaller premium for a better protected rate or a higher cap. Collars differ: if the sold option covers a larger amount than the bought one, the business may have to exchange more than it hedged.
Participating forwards
A participating forward gives a protected rate below the forward and a fixed share of any move above it, typically for no upfront premium. In the example below, the exporter is protected at 1.3540 on the full amount and keeps 50% of any rise above 1.3540. Built from options, that is a bought put on the full amount and a sold call on half of it, both at 1.3540.
Other structures
Forward extras, seagulls, structures with knock in or knock out barriers, and leveraged forwards rearrange protection and participation further. Some can produce outcomes worse than a forward: below a lower strike in a seagull, after a barrier removes protection, or on a leveraged amount. They suit some businesses and policies and not others, and should be understood in full before they are used.
No upfront premium is not the same as no cost
A structure with no upfront premium has a cost, carried somewhere other than cash. Depending on the structure, it can be:
- Reduced participation: a cap on the benefit, or only a share of it.
- A less favourable protected rate than the forward.
- Obligations at certain market levels: a sold option the business must honour if it is exercised against it.
- Conditional settlement: protection or benefit that applies only if a barrier is or is not reached.
- Leverage: an obligation to exchange a larger amount than the protected one.
- Path dependency: an outcome that depends on where the rate travels during the term, not only where it ends.
- Early termination costs: closing a structure before expiry is priced at the market value of every option in it.
A forward, a vanilla option and two structures compared
The table shows the rate the exporter in the example achieves on $1,000,000 USD under each alternative, for five possible rates at expiry. On this amount, each 0.0100 of rate is $10,000 CAD.
| USD/CAD at expiry | Forward at 1.3650 | Vanilla put at 1.3500 | Collar 1.3400 to 1.3900 | Participating forward |
|---|---|---|---|---|
| 1.3000 | 1.3650 | 1.3410 | 1.3400 | 1.3540 |
| 1.3300 | 1.3650 | 1.3410 | 1.3400 | 1.3540 |
| 1.3650 | 1.3650 | 1.3560 | 1.3650 | 1.3595 |
| 1.4000 | 1.3650 | 1.3910 | 1.3900 | 1.3770 |
| 1.4300 | 1.3650 | 1.4210 | 1.3900 | 1.3920 |
Illustrative terms for a six month hedge with spot at 1.3700 and the forward at 1.3650. Vanilla put rates are after its 0.0090 premium. The collar and the participating forward (protected at 1.3540, with 50% of any rise above it) have no upfront premium. Actual terms depend on market conditions when the hedge is arranged.
No alternative is best in every row. The forward is best when the rate falls, the vanilla option when it rises sharply, and the structures sit between. Choosing among them means deciding which outcomes the business most needs to avoid and what it is prepared to give up, not finding the one that looks best in a single scenario.
Using options within a policy
Options belong in a hedging policy like any other instrument. The policy should say which structures are permitted, whether sold options are allowed and on what amount, whether structures that can produce outcomes worse than a forward need separate approval, and how each is reported. At Vantry Capital Inc., options and structures are priced in Vantry ATI and executed by our dealing desk, with an indicative term sheet where needed; they are not booked online.
This article is general information about managing currency risk. It is not investment advice or a recommendation to use any instrument, and examples use illustrative rates and amounts, not quotations. Products are offered in Canada by Vantry Capital Inc., subject to eligibility and credit approval.