FX Options: What is Forex Options?

Trading in currency pairs

Trading currency pairs depends on the degree of liquidity between the currencies along with factors such as interest rate spreads and their volatility concerning other major currencies. Certain currencies are matched based on such parameters and become some of the preferred methods of trading for investors. The first currency in the pairing is the base currency, while the second one is the quote. Contracts are often cyclical, and while trading may occur in foreign currencies on the NSE, settlement always takes place in Indian Rupees. The daily settlement takes place a day after the trade occurs while the final settlement occurs two days after.

There are two primary ways of making profit in currency trade:

Derivatives:

Derivative trades through futures or options are a steadily growing area of forex trading. These types of transactions are very common among multinational corporations that hedge their currency exposure. They are also utilised by forex traders who often take up positions in response to ongoing world events. A wide variety of strategies that can be explored, such as hedging, spreads, straddles, butterflies, and strangles can be explored through options or futures. These will often involve high and low yield cross currency pairs and attempt to profit from by shorting low yield currencies. We will discuss them in greater detail in later sections of this article.

Carry Trades:

Another commonly employed method is carry trades which exploit interest arbitrage by borrowing low yield currencies and lending in high yield ones. The difference in interest rates denotes the profit margin for traders with the low yield currencies referred to as ‘funding’ currencies and the high yield ones referred to as ‘assets’. Currencies from countries with similar exports often make good pairs.

Risks:

So, what about the risks involved in cross currency trading and how you can hedge against those.

Interest rates play a huge role in determining the risks involved in cross currency trading, particularly in carry trades. Additionally, as settlements may not take place in the same currency as the trades themselves, profits may vary accordingly. When pairing currencies for trades, look for pairs that do not exhibit volatility against the U.S. dollar as they will usually behave in a non-volatile manner towards one another as well.

What is forex options?

Forex options give currency traders the right, but not the obligation, to buy or sell currency at a certain price (`strike price’ i.e. exchange rate in this case) at a particular date in the future (`expiry date’).

Call and put options

There are two types of forex options – call and put. A call option gives you the right to buy and a put option the right to sell forex options. A call option works better when you expect the value of a currency to fall. A put option works better in a situation where the currency is expected to strengthen.

Let’s illustrate this with an example. Let’s take the case of an electronics company, HighTech Corp. It imports several components from the USA. If the US dollar (USD) strengthens against the Indian rupee (INR), it will have to pay more for its components, driving up its costs. So the company decides to purchase 10,000 USD forex options at the current exchange rate of Rs 70. When the value of the rupee falls to Rs 75, it will be able to exercise the option and gain Rs 7 lakh, thus offsetting any losses from component imports.

If the USD moves in the opposite direction and the exchange rate now becomes Rs 65, it would not make sense for HighTech to exercise its option since it would incur a loss of Rs 7 lakh. In that case, it will not exercise the forex option. Its losses in this situation will be restricted to the premium it has paid to enter into the contract. Premiums are calculated using a host of factors, but they are generally a small fraction of the underlying. Premiums on these could climb around 3-4 percent. Keep reading to know more about advantages and how to trade forex options. 

Advantages of forex options

It’s not just importers and exporters who can benefit. Speculators too can take advantage of the changes in the value of a currency. The low premium makes it possible for them to take much larger positions through leverage. If you want to trade in Rs 1 crore worth of these options, you will only have to pay Rs 3 lakh as a premium to the broker. This enables you to trade in larger volumes, which increase your chances of making a profit.

The most significant advantage of forex options is that, while the upside can be unlimited, the downside is limited to the premium that you have paid. For example, if you purchased 100 USD options at the strike price of Rs 70, and the value of the INR keeps falling, you benefit to the full extent of the fall till the expiry date, even if it goes to Rs 100. In that case, you would have made a windfall of Rs 3,000! On the other hand, if the INR strengthens and reaches Rs 30, you can choose not to exercise your right. So, in that case, your losses will be restricted to the premium paid.

How to trade forex options

How to trade forex options in India? Foreign currency derivatives are available on Indian exchanges like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE). You can trade in forex options through your broker or the trading portal/ app. Forex options are available on currency pairs like INR-USD, euro, Japanese yen and Great Britain pound. The US Dollar, for obvious reasons, is the most traded currency, but apart from that, Euro, Japanese Yen, GBP, Chinese Renminbi are also traded frequently.

The currency market never sleeps. It is active day and night, across different time zones, for five days a week. However, there are thick and thin markets that denote when the market is more active and when it is tepid. The best time to trade is when the market is most active, meaning, more than one of the four markets are open. It is when you will find more significant fluctuations in the currency pairs. 

Forex options contracts can be executed only on the day of expiry. However, positions can be squared off before that by purchasing or selling put or call forex options. You can get forex options in contract units of USD 1,000, so it’s possible for small traders to benefit from currency fluctuations.

Cross Currency Swap

A cross-currency swap may be defined as the agreement two parties enter into such that they can trade currencies with ease. Over the course of such a swap, interest payments are exchanged time and again. Worth noting here is that the equal value principle is exchanged both, at the origin and at the time of maturity.

Understanding the Functioning of a Cross Currency Swap

Cross-currency swaps are made possible owing to the comparative advantages associated with borrowing. Borrowers are able to obtain the smallest cost associated with borrowing their domestic currency. That being said, they are likely to face the greatest costs associated with borrowing foreign currencies. Owing to these very facts, cross-currency swaps operate by identifying counterparties belonging to a foreign country that can borrow at an advantageous rate within their domestic country. During the same period of time, the original party borrows at their domestic rate following which the two parties swap their debt obligations with immediacy.

Consider the example featured below to gain a better understanding of this theme.

  CAD
Party A (Canadian) 7% 9%
Party B (French) 6% 10%

In the aforementioned table, Party A enjoys a comparative advantage over Party B in terms of borrowing €. However, rather than €, Party A would like to Borrow CAD. On the flip side, Party B has a comparative advantage over Party A in borrowing CAD, however, Party B would much prefer to borrow €. Should the two parties agree to enter into a cross-currency swap each of them can enjoy superior rates.

Understanding Quality Spread Differential

One way to calculate the potential gains via trade is by discerning what the quality spread differential for the same would amount to.

Also known by the acronym QSD, it can be calculated as follows.

QSD = CAD (Party A – Party B) – € (Party A – Party B)

Therefore, when we plug in the aforementioned table’s values,

QSD = CAD (7% – 6%) – € (9% – 10%) = 2%

Via a cross currency swap, therefore, each of the parties involved can benefit from a combined 2 per cent gain via the trade.

The principal for the same amount is traded at year 0 and interest payments are made by the counterparty over the course of the term. Once they reach maturity, the principal, as well as the interest on the foreign currency, are paid back by the counterparty. This concludes the swap obligation. The same after-swap cash flow exists provided the parties borrow at the domestic rate of the foreign currency.

Consider the following.

Exchange rate = 1.3 € /CAD, 2-year loan

Party A seeks to borrow CAD 50 M

Party B seeks to borrow € 65M (i.e., CAD$50 M x 1.3

Party A borrows € 65M at 9 %
Year 0 1 2
Cash Flow € + 65M – € 5.85 M – €70.85
 
Party A cash flow from a swap with Party B
Year 0 1 2
Cash Flow € – €65 M + €5.85 M + €70.85
Cash Flow CAD + CAD 50 M – CAD 3 M – CAD 53 M
 
Party A after-swap cash flow
Year 0 1 2
Cash Flow CAD + 50 M – 3 M – 53 M

In the above table, Party A borrows at 9 % € and swaps their debt with Party B who proceeds to borrow at a 6 % CAD rate. AS a result of this swap, both parties are able to save 1 % which wouldn’t have been a possibility had they borrowed at their available foreign rate. Party B’s cash flows lie in direct opposition to those of Party A’s.

Examining the Benefits and Shortfalls of Cross Currency Swaps

Cross currency swaps bring with them the following advantages.

– Those that partake in such swaps are able to borrow at lower rates as opposed to available foreign rates.

– Cash flows are known owing to cross currency swaps and parties involved can home in on an exchange rate at the origin.

Cross currency swaps bring with them the following risks.

Should the counterparty involved in a swap fail to meet their payments, the original party can’t pay their loan. Swap banks mitigate such risks as they can adequately assess the creditworthiness of the party and the likelihood of their meeting their obligations.

Conclusion

Cross currency pair trading allows you to diversify your portfolio. It allows traders to profit from both differences in interest rates at different economies as well as from exchange rate disparities. But it takes some practice to trade with confidence since it also involves high volatility.