Foreign exchange options
Foreign Exchange Options. The underlying asset is a sum of money in a foreign currency. The option gives the holder the right to buy (or sell) the underlying asset at (or by) a certain date for a certain price. Options are sometimes referred to as 'contracts'. There is a fee for entering into an options contract.
Example
Suppose a UK manufacturing firm is expecting to be paid $100,000 for a piece of engineering equipment to be delivered in 90 days. If the exchange rate goes down over the next 90 days the UK firm will lose money, but if the rate goes up then the UK firm will make a profit. The UK firm can purchase an option (the right to sell part or all of their expected income for sterlins at a given rate near todays rate) to mitigate their risk of exchange rate fluctuation over the 90 days. Conversely another party may wish to have the reverse option for a similar reason. A Market maker will buy and sell these options with the aim of making a profit while not incurring too much risk.
See Also
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