A major drawback of a forward exchange contract is that it’s a binding contract which must be performed. Some investors may be uncertain about the earnings they will make in several months time and therefore would be unable to enter into a forward exchange contract without the risk of contraction to sell more or less than they will receive.
The use of a currency option overcomes this problem. A currency option is an agreement that gives the holder the right but not the obligation to buy or sell a certain quantity of foreign currency at a specified exchange rate at a specified future time.
Currency options are useful to companies in the following situations.
When there is uncertainty about foreign currency receipt or payment either in timing or amount. If the foreign exchange transaction does not materialise then the currency option can be sold in the market (if it has any value) or it can be exercised if it will make a profit
- It can be used to support a tender for an overseas contract priced in foreign currency.
- It can be used to allow publication of price-lists for goods in foreign currency.
- It can be used to protect the imports or exports of price sensitive goods.
Currency options have the following limitations:
- The cost of the option is very high, approximately 5% of the total value
- Options must be paid for as soon as they are bought.
- Traded options are not available in every currency. They are only available in standard currency.