Currency Option - Explained
What is a Currency Option?
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Table of ContentsWhat is a Currency Option?What are the Types of Currency OptionFeatures of the Currency OptionsAcademic Research for Currency Option
What is a Currency Option?
A currency option is a type of contract that grants the buyer the right to purchase or sell an amount of a specific currency at a fixed exchange rate and on a particular date. A currency option only confers the right and not an obligation to the buyer, that means a buyer is not under any compulsion to buy or sell a given amount of the currency. However, one benefit of currency option to the holder is that it allows the holder to benefit from the movements of the currency and also reduce the risk that the option holder is exposed to.
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What are the Types of Currency Option
There are two major types of currency option, the American currency option and the European currency option. The American currency option allows the holder to buy or sell an amount of a given currency on any date or at the fixed date while the European option allows that sale or purchase to be made at a fixed future date. The standard Currency option is however more straightforward, it is otherwise called vanilla. Currency option is not restricted to a particular set of individuals, rather, anyone can be a currency option holder depending on the movement of prices.
Features of the Currency Options
The major features of a currency option include the following;
- Currency option allows the holder to enjoy the benefits of movements of currency pairs and also limit the risks the holder faces.
- Currency option aids flexibility in investment, it is a unique trading tool that traders use when negotiating.
- It gives the buyer the right but not an obligation to buy and sell an amount of a specific currency at a fixed future date.
- A currency option has a fixed future date, otherwise called its expiration date.
- Premium and strike (exercise) price are present in currency options.
In exercising currency option, valuation is an important concept and this entails two core components which are the intrinsic and temporary value of the asset. The intrinsic value of an asset is often referred to as the price of the less which is below the strike of the option. The temporary value however is the amount at which the option value exceeds the intrinsic value of the asset. It is temporary because this difference is not static, it is often short-lived. Furthermore, in currency option, it is vital to know that the differences in the interest rates of the currency pair plays out in how the negotiation or price would turn out. The timing is another crucial factor to consider.