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What they are
Currency options have gained wide acceptance as valuable tools in managing foreign exchange risk. They are used extensively and make up about 10% of total currency trading turnover. Currency options bring a much wider range of hedging alternatives to portfolio managers and corporate treasuries and are actively used by many companies as a risk management tool.
Simply stated, an option is a choice or a right. The buyer of an option acquires the right and not the obligation, to buy or sell an underlying asset under specific conditions in exchange for the payment of a premium. It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to perform.
A call option conveys the right to buy the underlying asset, and a put option gives the option buyer the right to sell.
How they are priced
The premium quoted for an option at a particular time represents what the market thinks is the option's current value, and is comprised of two elements: intrinsic value and time value.
Intrinsic value is simply the difference between the spot price and the strike price (the strike price is the price the asset can be bought or sold in the future). A put option will have intrinsic value only when the spot price is below the strike price. A call option will have intrinsic value only when the spot price is above the strike price. Options which have intrinsic value are said to be "in-the-money."
Time value is more involved. When the price of a call or put option is greater than its intrinsic value, it is because it has time value. Time value is affected by five variables:
• the spot or underlying price,
• the expected volatility of the underlying currency,
• the strike price,
• time to expiration, and
• the difference in the "risk-free" rate of interest that can be earned by the two currencies.
Time value falls toward zero as the expiration date approaches. An option is said to be "out-of-the-money" if its price is comprised only of time value.