Currency option

A futures contract binds you. If the rate moves your way, you do not get to keep the gain — the contract takes it back.

An option does not bind you. You pay a premium up front and buy a right. If the rate moves your way, you walk away from the option and take the market rate. If it moves against you, you use the option.

A currency option is that right applied to an exchange rate. The workbook defines it as an option that gives the buyer the right, but not the obligation, to buy or sell an agreed amount of a certain currency with another currency at a specified exchange rate on or before a specified date in the future.

A call is the right to buy the base currency. A put is the right to sell it. An importer who fears a stronger dollar buys a USDINR call. An exporter who fears a stronger rupee buys a USDINR put.

The buyer's loss is capped at the premium. The writer's is not: the writer receives the premium and takes on the obligation.

India has these on the exchanges. The first exchange traded currency option launched on USDINR in 2010.

The definition (Chapter 2, section 2.3.3): a foreign exchange option (currency option) is an option that gives the buyer the right, but not the obligation, to buy or sell an agreed amount of a certain currency with another currency at a specified exchange rate on or before a specified date in the future.

The launch sequence (Chapter 4, section 4.9). Exchange traded currency options are regulated by SEBI as well as RBI and sit in the currency derivatives segment alongside currency futures and interest rate derivatives. In 2010 the first exchange traded currency option was launched on USDINR, then on EURINR, GBPINR and JPYINR, and subsequently on the cross-currency pairs EURUSD, GBPUSD and USDJPY.

Contract specifications — the INR pairs:

The cross-currency options differ in three places: the premium is quoted in USD for EURUSD and GBPUSD and in JPY for USDJPY; tick size is USD 0.0001 or JPY 0.01; strike intervals are USD 0.005 or JPY 0.5; and trading runs to 7.30 pm. Settlement is still cash settled in Indian Rupees, using the FBIL USD-INR reference rate and the corresponding FBIL cross rate.

Style. In India, only European options — the right to exercise on the specified date only — are allowed in the OTC market as well as in the ETCD segment. A holder who wants out earlier sells the option in the secondary market rather than exercising. Other things equal, an American option's price is always higher than or equal to a European one, which is why the restriction matters to pricing.

Exchange traded versus OTC. The differences mirror futures versus forwards: OTC options are bilateral, non-standardised, priced by negotiation with banks as market makers — and the workbook notes the same bank may offer different option prices to different customers — with low liquidity and bilateral settlement mainly through physical delivery, gross without netting. Exchange traded options are standardised, price-discovered on a central platform, highly liquid, and cash settled in INR with multilateral netting and a clearing corporation guarantee. OTC keeps one advantage: customisation to a client's exact requirement.

An importer's call. The workbook's own figures from Chapter 5, section 5.3.7.2. XYZ Ltd must pay USD 100,000 at the end of the month. It buys USDINR call options at a strike of 82.80 for a premium of Rs 0.30.

The cap holds and the floor does not exist. Above 83.10 XYZ is protected; below it, XYZ keeps the benefit less the Rs 30,000 premium. A long futures hedge would have fixed the rate and given up those last two rows entirely.

Sizing from a rupee amount. A student going abroad has a loan of Rs 15,00,000 sanctioned and must pay a university in one month. He wants an exchange traded call at a strike of Rs 83.00.

Reading the strike ladder. With a strike interval of Rs 0.25, the strikes around 83.00 are 82.50, 82.75, 83.00, 83.25, 83.50 — and the exchange must list at least 12 ITM, 12 OTM and 1 ATM, so all of these exist. A tick of Rs 0.0025 on one lot is worth Rs 2.50, so a premium quoted at 0.3025 rather than 0.3000 costs the student 18 x 2.50 x 1 = Rs 45 more in total.

Chapter 2, section 2.3.3, gives the definition; Chapter 4 is the whole chapter — section 4.3 on European versus American style, section 4.9 for the contract specifications of both the INR and cross-currency option contracts, and section 4.10 for the OTC comparison. Chapter 5, sections 5.3.7.1 and 5.3.7.2, is where the hedging cases are worked. The heavily examined facts are the lot sizes (1,000 units, 100,000 for JPY), the premium currency, the Rs 0.0025 tick, the Rs 0.25 strike interval, European style only in India, cash settlement in INR against the FBIL reference rate, and the expiry rules for monthly and weekly contracts.

• All Indian currency options are European style, in the OTC market as well as on the exchanges. An American-style answer is wrong for India.
• European style does not trap you in. You can sell the option in the secondary market before expiry — the workbook says so expressly.
• The premium is quoted in the quotation currency: rupees for the INR pairs, USD for EURUSD and GBPUSD, JPY for USDJPY. But settlement of the cross-currency contracts is still cash settled in Indian Rupees.
• JPYINR is the odd lot: 100,000 yen a contract, quoted per 100 yen, while the other INR pairs are 1,000 units.
• Monthly expiry is two working days before the last business day, at 12.30 pm. Weekly USDINR options expire every Friday at 12.30 pm — two different rules.
• Only the writer posts mark-to-market margin. The buyer's maximum loss is the premium already paid.
• Option price bands are delta-based, computed daily from the previous close and volatility, with a minimum operating range — not the fixed percentage bands used for futures.
• The buyer of the option is not necessarily bullish on the currency. An importer buying a call is hedging a payable, not speculating.