This document discusses currency options. It defines a currency option as a financial derivative that gives the buyer the right to buy or sell a currency at a specified exchange rate during a specified period of time. There are two types of currency options: put options, which give the right to sell one currency and receive another, and call options, which give the right to buy one currency with another. Currency options provide advantages like limiting risk to the premium paid and allowing profits from favorable exchange rate movements, but they also have disadvantages like losing the full premium if the option expires out of the money or is terminated early.

1. THE UGANDA INSTITUTE
OF BANKING &
FINANCIAL SERVICES
UIBFS
ISO 9001:2008 CERTIFIED
Trade Finance Facilities
Swift and Other Bank International Payments
Vostro Accounts and Nostro Accounts
Dealing in Foreign Currencies
Forward options
Forward Contracts
MODULE COVERAGE
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How Collections Work
Currency options
Factoring

2. THE UGANDA INSTITUTE
OF BANKING &
FINANCIAL SERVICES
UIBFS
ISO 9001:2008 CERTIFIED
What is currency option?
• A currency option (also FX or forex option) is a financial derivative that gives the
buyer the right (not the obligation) to buy (call) or sell (put) a currency at a
specified exchange rate during a specified period of time. The contract grants the
holder the right, but not the obligation, to buy or sell currency. The option owner
can exercise this right when it is to his/her advantage before the expiry.
• For this right, a premium is paid to the bank/broker. Currency options are one of
the best ways for corporations or individuals to hedge against adverse exposure
movements in exchange rates at future dates and to also take advantage of
favorable movements in the exchange rates. Investors can hedge against foreign
currency risk by purchasing a currency option “put” or “call”. When the Currency
option is bought, the risk is limited to the premium paid for the derivative.
The value of an option contract at its expiry date is the value which is realized by the
holder in exercising his option at that point. For example:
• If the option contract lapses and the holder gains or the contract has intrinsic value
it is said to be 'in the money'
• If the option contract lapses and the holder loses or the contract has negative
intrinsic value it is said to be 'out of the money'
• If the option contract lapses and the holder neither gains nor loses (the contract
has no intrinsic value) it is said to be ‘at the money' or ‘at par’
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3. THE UGANDA INSTITUTE
OF BANKING &
FINANCIAL SERVICES
UIBFS
ISO 9001:2008 CERTIFIED
There are two types of currency options:
a. Put option- This gives the right but not the obligation to sell one currency
and receive another currency at the strike rate.” Put” options give the
option to sell at a certain price, so the buyer would want the rate to go
down in order to gain.
b. Call option- This gives the customer the right but not the obligation to
buy the currency with another currency at the strike rate. “Call” options
give the option to buy at certain price, so the buyer would want the rate
to go up in order to gain.
Features of currency option contracts
1. The currency pair should be indicated- e.g. US Dollar - Uganda Shillings
(USD- UGX) spot rate.
2. The type of option should be clearly stated either “call” or “put” options.
3. The contract amount should be stated - e.g. USD 1,000
4. The currency of the premium should be quoted- e.g. UGX
5. The currency outstanding position shall be in USD.
6. The maturity of the contracts should be indicated- e.g. Shall not exceed
twelve months.
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4. THE UGANDA INSTITUTE
OF BANKING &
FINANCIAL SERVICES
UIBFS
ISO 9001:2008 CERTIFIED
7. The mode of payment
and currency in which
the contracts should be
settled- e.g. cash in
Uganda Shillings.
8. The basis of the
settlement price should
be stated- e.g. Bank of
Uganda Reference Rate
on the date of expiry of
the contracts.
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5. THE UGANDA INSTITUTE
OF BANKING &
FINANCIAL SERVICES
UIBFS
ISO 9001:2008 CERTIFIED
How the currency option works
The pricing of an option uses a formula which looks at both the current value of the
currency and a time value, calculated on the basis of market expectations,
volatility and any difference in interest rates between the two currencies specified
in the contract. The best way in pricing an option is to set the price low enough to
attract buyers, but also to set it high enough to attract sellers and guarantors for
the contract.
Options can be used to reduce the risk of unexpected movements in the currency
market. When a currency option is bought, then losses will be limited simply to the
price of the option. However, when a currency option is sold; the losses can be
more substantial and are potentially unlimited.
The advantages and disadvantages of a forex options
• Currency options have the following advantages:
• The customer can choose to exercise the currency option when the rates are
favaourable. Alternatively, he may choose not to exercise the foreign currency
option or to let the option expire (not exercise).
• Limited risk - Provides protection against adverse currency movements with the
potential to financially benefit from favourable Currency movements.
• Considerable profit potential due to taking advantage of favourable changes in the
exchange rate.
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6. THE UGANDA INSTITUTE
OF BANKING &
FINANCIAL SERVICES
UIBFS
ISO 9001:2008 CERTIFIED
Currency options have the
following disadvantages:
a. If the foreign currency option
expires and is not exercised, it
is worthless as the premium
you paid becomes an
additional cost since it is not
refundable
b. The expiry date or term cannot
be extended
c. The currency option holder
may not recoup the full
premium paid if the foreign
currency option is terminated
prior to the expiry date
d. Premium has to be paid up-
front.
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