Foreign Exchange (FX) Options
Since our inception, we have committed to equipping our clients with tailored risk management tools, no matter the size or sector of their business. Foreign exchange options can seem like a complicated way to protect their bottom line. However, if implemented correctly, they offer an effective approach to mitigating risk and achieving better cash flows.
We not only offer a wide range of FX options designed to de-risk your business from foreign exchange volatility, but we’ll also guide you through the pros and cons of any product or approach. However, it’s important to note that the use of FX options won’t be the best solution in every instance and may not be the right approach for every business.
Our dedicated team of qualified risk management professionals takes the time to fully understand your current and potential future exposures, conducting thorough reviews of risks and assessing potential impacts on your business. We’ll then work with you to create bespoke solutions to reduce or minimise risk.
At the end of this process, you will have a currency hedging strategy designed specifically for your business, which protects you against currency volatility and, in certain instances, allows you to react when the markets move.
Why do you need to manage your risk?
Fluctuations in the currency market can potentially result in significant financial losses for a business. However, in managing your foreign exchange risk effectively, you can protect your company from adverse movements in the currency market for current and defined future periods. In turn, this will ensure that your bottom line and operating profit are protected, as well as helping you to fulfil your business goals.
By mitigating your business’s foreign exchange risk, you could achieve the following simply and effectively:
- Protect your business’s profit margins
- Effectively manage the impact that currency volatility has on your cash flows
- Secure working capital at budget rates
- Support your balance sheet
- Enable you to accurately forecast your business’s cash flows
- Retain a competitive edge through consistent pricing, irrespective of exchange rate movements
What is a foreign exchange option?
- A foreign exchange (FX) option is a type of contract that gives the buyer the right, but not the obligation, to buy one currency and sell another at an agreed rate of exchange at a point in the future. This is known as a vanilla option; the most basic form of an FX option, but still very effective.
- An example of a vanilla option is to buy the right to purchase one million dollars, selling pounds, at a rate of $1.30 in three months’ time.
- When buying a vanilla option, you will pay an up-front premium, much like when buying insurance. The premium amount will vary depending on a number of factors.
- In addition to vanilla FX options, Smart can offer a variety of structured FX options. These products are created by combining two or more FX options contracts to create a more bespoke solution with variable and tailored contract specifications.
- By utilising an FX options contract, businesses can protect themselves against adverse movements in exchange rates and may potentially benefit from favourable movements.
When are FX options used?
A business might put an FX option in place to both protect themselves from adverse movements in the currency market, and to give themselves the ability to factor in cash flow uncertainty, price flexibility and so on. If you leave yourself exposed to the movement in exchange rates when selling and/or buying from overseas, or with any foreign currency transactions your business is engaged in, this could potentially result in a significant financial loss for your business, which could be significant and debilitating. However, FX options contracts can be used as part of a risk management programme to avoid this scenario.
As previously stated, vanilla options give you the right – but not the obligation – to exchange funds at the pre-agreed rate. So, if for example, the market rate is less favourable than the pre-agreed rate at the time you wish to exchange, you will exercise your option.
If the market is more favourable than the pre-agreed rate, then you can take advantage of this – there is no obligation to use the option. However, please note that for some structured FX options, there may be an obligation to exchange at a rate less favourable than the prevailing spot rate.
How do FX options contracts differ from forward contracts?
Unlike a forward contract, FX options contracts allow you to adjust your strategy according to business needs and market movements. If used correctly, they can be extremely versatile tools which can ensure that your money is protected.
When you buy vanilla options, whilst they require a non-refundable premium to be paid, they cannot have a negative mark-to-market value. This means you will never be called to post a deposit (also known as margin/collateral) against a vanilla option you have purchased. Some structured FX options may require you to place deposits, however.
FX options can be utilised as a standalone hedging product but can also be used to complement forward contracts or spot contracts as part of a diversified and more bespoke programme.
We offer a variety of different FX options contracts depending on your specific requirements.
What Foreign Exchange Options do we offer?
The number and variety of FX options contracts available in the market can be bewildering. The majority of FX options contracts traded by Smart are vanilla options and simple structured products. We believe that less is more when it comes to effective risk management. Below we describe just four common products that will give you a flavour of what can be accomplished with FX options contracts.
Vanilla options are an agreement between two parties that gives the buyer of the option the right, but not the obligation, to buy or sell one currency in exchange for another at an agreed exchange rate on a predetermined date. A premium is payable on vanilla options.
The buyer of the vanilla option nominates the currency pair, expiry date, notional amount and strike rate. Smart Currency Options Ltd will calculate a premium payable by the buyer of the vanilla option. The premium is payable within two business days.
Collar options provide you with a known worst-case rate (known as the protection rate) and a best-case rate (known as the collar rate), which you can use to transact on a given date in the future. You are able to participate in favourable movements in the spot rate between the participation and collar rates.
Collar options may not require a premium to be paid.
A participating forward provides a secured protected rate, while still allowing beneficial moves on a predetermined portion of the amount hedged.
If the spot rate at expiry is less favourable than the protection rate, you exchange the full contracted amount at the protection rate. However, if the spot rate is more favourable than the protected rate, then the buyer of the contract is only obligated to transact a predetermined proportion of the hedged amount at the protected rate. They are then free to transact the remainder at the spot rate. For example, you might be obligated to exchange 50% at the protection rate with the capability to exchange the remaining 50% at the more favourable spot rate.
Participating Forwards may not require a premium to be paid.
A forward extra provides a secure protection rate, while still allowing beneficial moves up to a pre-determined trigger level.
- If the trigger level is met or exceeded either on or before the expiry date (depending on the contract specification), the buyer of the forward extra is obliged to deal at the protected rate.
- If the trigger level is not breached, and the rate on expiry is in-between the protection rate and trigger level, the buyer of the forward extra can transact at the spot rate.
- If the spot rate at expiry is less favourable than the protection rate, the buyer of the forward extra can transact at the protected rate.
Forward extras may not require a premium to be paid.
Example of a Vanilla Option
Your UK-based company imports materials from the US and needs to pay the supplier $500,000 in six months’ time.
The company buys a vanilla option for six months with a protected rate of 1.3250. The premium is 2.5% of the contract value.
Two possible scenarios could occur:
Unfavourable market movements:
GBP/USD weakens; however, the company is protected. The company is therefore entitled to buy the full $500,000 at the pre-arranged rate of 1.3250.
Favourable market movements:
GBP/USD strengthens, so the company simply lets its vanilla option expire and takes advantage of the improved market rate of, say, 1.3650.
In both situations, your money is protected from adverse market moves. Your bottom line, profits and business goals are therefore protected too. Please note that the premium you pay is the cost of purchasing the vanilla option.
Typical advantages and disadvantages of foreign exchange options
Structured FX options contracts differ greatly. Therefore, the advantages and disadvantages vary per contract. Please ensure you fully read and understand any Term Sheet prior to dealing and speak to your Smart representative if you have any questions.
- Most products will provide you with full protection against adverse movements in the currency market.
- Unlike forward contracts, FX options may enable you to react accordingly when the markets move.
- FX options may provide your business with a greater degree of flexibility than other risk management tools.
- This flexibility may allow you to agree to terms that better suit the needs of your business.
- A premium may be payable upon the purchase of our FX options contract.
- For some structured FX options, there may be an obligation to exchange at a rate less favourable than the prevailing spot rate.
- Some structured FX options are subject to variation margin, meaning that you are asked to pay a deposit if the spot rate moves significantly prior to expiry (also known as a margin call).
- FX options are more complex than other risk management tools. Our qualified risk management professionals can help you with any questions you might have.
Why Choose Smart Currency Options?
We can assist you on how best to implement a bespoke hedging strategy for your company. We follow a thorough, four-step process to ensure that your strategy is correctly implemented, monitored and refined.
FX options may look complicated from the outset and they must be used appropriately, which is why we have a dedicated team of qualified risk managers on hand to offer tailored and thorough support for your business. Unlike the majority of our competitors, none of our traders are paid on a commission basis – i.e. our traders do not profit directly from the money made on a specific FX option contract.
Our FX option contracts are offered through Smart Currency Options Ltd, which is a wholly owned subsidiary of Smart Currency Exchange Ltd. We are regulated by the Financial Conduct Authority (FCA No. 656427).
Your funds are safe and secure with us, as they are held in fully segregated accounts and are ring-fenced.
If you’d like more information regarding risk management strategies, call 020 7898 0500 or fill in the form below to discuss your specific requirements with us.
Fill in the form below to discuss your specific requirements with us
Option contracts are offered by Smart Currency Options Limited (SCOL) on an execution-only basis. This means that you must decide if you wish to obtain such a contract, and SCOL will not offer you advice about these contracts.
This material provides you with generic and illustrative information and in no way can it be deemed to be financial, investment, tax, legal or other professional advice, a personal recommendation or an offer to enter into an option contract and it should not be relied upon as such. Any changes in exchange rates and interest rates may have an adverse effect on the value, price or structure of these instruments.
SCOL shall not be responsible for any loss arising from entering into an option contract based on this material. SCOL makes every reasonable effort to ensure that this information is accurate and complete but assumes no responsibility for and gives no warranty with regard to the same.
Foreign exchange options can carry a high degree of risk and are not suitable for everyone as they can have a negative impact on your capital. If you are in doubt as to the suitability of any foreign exchange product, SCOL strongly encourages you to seek independent advice from suitable financial advisers.
Consulting a website or receiving a publication does not constitute a customer relationship and SCOL shall not have any duty or incur any liability or responsibility towards any person or entity as a result thereof.
SCOL is a wholly-owned subsidiary of Smart Currency Exchange Limited, and is authorised and regulated by the Financial Conduct Authority to carry out MiFID business with reference number 656427.
SCOL is a private company limited by shares registered in England and Wales. Company number 9034947. The registered office address is at 26-28 Hammersmith Grove, London W6 7BA.