FX Options Application

FX Options Application

Lindsey Matthews

30 years: Risk management & derivatives trading

Investors and corporations commonly utilise FX options as a tool to control and protect themselves from the risks associated with currency volatility. Join Lindsey as he explains how FX options are used and also explains what barrier options are.

Investors and corporations commonly utilise FX options as a tool to control and protect themselves from the risks associated with currency volatility. Join Lindsey as he explains how FX options are used and also explains what barrier options are.

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FX Options Application

7 mins 48 secs

Key learning objectives:

  • Understand when we might use FX options

  • Outline barrier options

Overview:

FX options are typically used by investors and businesses as a way to manage and hedge against the risks associated with currency fluctuations, for example, an investor who has a large holding of a particular currency may use FX options to protect against a potential decline in the value of that currency. An example of an FX option an investor may use is a barrier option used in situations where they have a view on the potential direction of a currency's exchange rate, but want to limit their potential losses if the currency moves in the opposite direction.

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Summary

How are FX options used?

FX options are financial derivatives that give the holder the right, but not the obligation, to buy or sell a specified amount of a currency pair at a predetermined price on or before a certain date. FX options can be used to protect against potential losses from a decline in the value of a currency. 

For example, if a trader expects to receive a certain amount of Swiss francs in the future and is worried that the value of the Swiss franc will fall, they could purchase an FX option to protect against potential losses such as the GPB call - CHF put. 

If the value of the franc falls below a certain level, the trader can exercise the option and buy a certain amount of GBP, in order to protect their investment. The value of the option would be determined by the difference between the exchange rate at expiration and the predetermined strike price.

What are barrier options?

Barrier options are a type of financial derivative that involves a trader entering into a contract to either buy or sell a specified amount of an underlying asset at a predetermined price on or before a certain date. 

In the case of FX barrier options, the underlying asset is a currency pair and the predetermined price is called the "barrier" or "knock-out" level. If the price of the currency pair reaches or exceeds the barrier level at any time before the option expires, the option is automatically "knocked out" and becomes worthless.

These barrier options are known as being "path dependent" because their value depends on the path that the currency follows, rather than just its value at expiration. The more volatile the currency, the more discount an investor can expect for adding a barrier to the option, but the option will also be worth more in the first place.

Barrier options can be used in a variety of ways in FX trading. For example, a trader may enter into a barrier option contract to buy a currency pair if it reaches a certain price, in order to take advantage of a potential price increase. Alternatively, a trader may enter into a barrier option contract to sell a currency pair if it reaches a certain price, in order to protect against potential losses from a price decline. 

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Lindsey Matthews

Lindsey Matthews

Lindsey runs Perfordiant, an investment risk and performance consulting firm. He has worked in financial markets since 1992. Lindsey became an MD in fixed income and equities, ran a Risk function, and was on the management team of an Asset Management fintech business. Lindsey is now a Visiting Fellow at the Henley Business School, and resides on the board of CFA UK.

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