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 Foreign currency option 

What is it?

A foreign currency ‘put’ option gives you the right, but not the obligation, to sell to your bank a nominated foreign currency at a fixed exchange rate (the strike rate) either on a particular date or during a defined period of time.

As an exporter entering an export contract in a foreign currency, a put option enables you, at the time you sign the export contract, to set a lower limit on the amount of Australian dollars you’ll receive in exchange for payment in foreign currency from your buyer.

How does it work?

When you buy a foreign currency put option from a bank, you acquire the right, but not the obligation, to sell the nominated foreign currency to your bank at an agreed exchange rate. You can exercise the option to sell the currency on or until the expiry date of the put option contract. However, if at the time your buyer pays you the market exchange rate is more favourable than the agreed strike rate, you’re not required to exercise the option.

A foreign currency put option is different to a forward exchange contract, which obliges you and your bank to conclude an agreed transaction in a foreign currency on a particular date or within a defined period of time.


The diagram below illustrates a typical foreign currency put option.

Foreign currency option product diagram

 

Notes to diagram

  1. You enter into an export contract with your buyer which states that on the payment date, the buyer will pay you in a currency other than Australian dollars (AUD).
  2. You purchase a foreign currency put option from your bank: an option to sell to the bank on the payment date, at a fixed exchange rate (strike rate), the foreign currency you receive from the buyer. You pay a premium to the bank for the option.
  3. You provide goods or services to your buyer in accordance with the export contract.
  4. You send the buyer an invoice for payment in foreign currency.
  5. The buyer pays you in foreign currency on the payment date.
  6. If at the time of payment the strike rate agreed in the option is more favourable to you than the market exchange rate, you can exercise the option and sell the foreign currency to the bank at the strike rate. If it is not, you are not obliged to exercise the option and can convert the foreign currency at the market exchange rate.
  7. If you exercise the option, the bank pays you the Australian dollar equivalent of the foreign currency payment at the strike rate.

What are the pros and cons?

Pros Cons 
Allows you to manage the risk of exchange rate movements between the foreign currency of your export contract payments and Australian dollars Your bank may have a minimum foreign currency amount for a foreign currency option contract

What costs are involved?

When you buy a foreign currency put option, you pay fees and a risk premium to your bank. The amount of the risk premium depends on factors including the bank’s view of the current exchange rate and future exchange rate movements, the agreed strike rate and the term of the option contract. Depending on your bank’s assessment of these matters, it may quote a higher premium for a foreign currency option than for a forward exchange contract.

 

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