Robert A. Feldman
In recent years interest in ways of managing foreign currency exposure has increased considerably in light of large and, at times, erratic changes in exchange rates. Forward markets for foreign exchange have, of course, existed for some time for most major currencies, and the ways in which these markets can be used to reduce the risks from foreign currency exposure are well known. A more recent innovation, foreign currency options, adds a new dimension to the ways of protecting against (hedging) exchange rate risks.
Basically, a foreign currency option is a contract that provides its holder the right (but not the obligation) either to purchase or sell a predetermined amount of foreign currency at a specified exchange rate on or before the maturity date of the contract. Although their use is not yet widespread, foreign currency options appear to have a great deal of potential as reflected in the establishment of trading in these options on organized exchanges in the United States, Europe, and Canada, and in the rapid increase in trading volume. Some exchanges have recently increased the number of currencies in which options contracts are traded, while others have just started trading in foreign currency options for the first time. Foreign currency options may ultimately become an important financial instrument in facilitating international trade by reducing some of the risks associated with a flexible exchange rate system.
Along with highlighting the terminology, mechanics, and advantages associated with using foreign currency options to hedge foreign currency exposure, this article discusses market arrangements for buying and selling such options. Given space limitations, however, the discussion is brief and selective. For example, the relationship between options, forward, and spot markets for foreign exchange is not explicitly discussed, although this interaction can play an important role in the development of the options market.