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Overview

A buyer of an option contract holds the right but not the obligation, to buy/sell the currency at a mutually agreed price (Strike Price) on or before a certain date (Expiration date). Therefore, on the expiration date if the ongoing rate is favourable as compared to the option strike rate, the buyer of the option can walk away from the option contract.

There are two types of option contracts, Call and Put.

A Call option gives the buyer the right to buy the currency, while the Put option gives the buyer the right to sell the currency. The buyer of the option has to pay a price to the seller referred to as the option “Premium”. Thus the loss for the option buyer is restricted to the option premium paid, while it allows the buyer to benefit from favourable movements in the currency.

Benefits

  • To hedge against foreign exchange rate risk arising from trade exposures (export/import).
  • To hedge against foreign exchange rate risk arising from foreign currency investments or funding in any currency.
  • To provide cover against contingent exposures like foreign currency tenders.

Example: Call Option
If the spot rate is USD/INR = 46.00 and when the option strike price is:

  • 45.85 : It is called In the Money Option (ITM)
  • 46.00 : It is called At the Money Option (ATM)
  • 46.10 : It is called Out of the Money option (OTM)

Factors governing premium

  • Volatility: Greater the volatility, higher the premium.
  • Tenor: Longer the tenor, higher the premium.
  • Strike Price: Premium differs for ATM, ITM and OTM contracts.

Regulations

Customers having genuine foreign exchange exposure can buy options to hedge their exposures. While selling of naked options by customers is prohibited, RBI has permitted customers to enter into cost reduction structures, which involve simultaneous buying and selling of options.

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