A vanilla option provides the right but not the obligation to buy/sell a currency at a specified protected rate at a specific future date, while allowing the holder of the vanilla option to benefit from favourable movements in the market. A premium is payable on a vanilla option.
An example of how a vanilla option works
A UK-based company imports materials from the US and needs to pay a supplier $500,000 in six months’ time.
- would like to benefit from a favourable exchange rate and 100% rate protection
- is willing to pay a premium for this
2. Current Forward Rate
The forward rate for a six-month period is
The company buys a vanilla option for six months with a protected rate of 1.3250. The premium is
There are two possible scenarios
Unfavourable market moves
GBP/USD weakens. At maturity, the exchange rate is 1.2500. The company is entitled to buy the full $500,000 at 1.3250.
Favourable market moves
GBP/USD strengthens. At maturity, the exchange rate is 1.4575. The company lets its vanilla option expire and simply buys $500,000 at the market rate of 1.4575, thus benefiting from the 10% improvement in the currency exchange rate.
Advantages of the vanilla option
- Provides protection on 100% of the company’s exposure
- Allows the company to benefit in full from favourable currency moves
Disadvantages of the vanilla option
- A premium is payable and non-refundable
- Not subject to deposit and/or variation margins
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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.
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