Currency Call Options
A currency call option is an option contract that offers the holder a non-compulsory opportunity to purchase a specific currency he does not own at a specific exchange rate at a definite future date. If, at this date, the exchange rate specified in the option contract is less than the same rate in the currency market, the holder may sell the contract at a profit. He may also exercise his rights by purchasing the currency at the contract rate and then, subsequently, resell them for a profit at the market rate.
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Significance
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An option contract is a simple financial derivative entered into between two parties with regard to the price of an underlying asset (strike price) at a specific future date (expiry or expiration date). If the strike price of the underlying asset exceeds or is lower than the market price of that asset at the date of expiration, depending on the type of contract, then the holder has the right to either buy or sell a specified quantity of that asset at the contract's strike price. In other words, the holder may exercise her rights, provided that the strike price is more advantageous than the asset's market price at the time of expiration.
Potential
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Though there exists a plethora of options styles and contract terms, all options are subdivided into two categories, depending on whether the holder believes that the price of an asset will rise or fall. An investor enters into a call option if he believes that the price of an underlying asset will rise in the future. As such, the strike price of the option must be below the level at which the holder believes it will be at the time of expiration. Assuming, therefore, that price of the underlying asset exceeds the strike price, as the holder expects, he may exercise the terms of the contract and purchase some quantity of the underlying asset at the lower strike price.
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Function
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Currency call options are applicable to investors who believe that the price of a specific foreign currency will rise with respect to a currency which they currently hold. In other words, a currency call option would be to an investor's advantage if she expects a decline in the value of her own currency with respect to another. To this extent, the currency which is not held serves as the underlying asset. Provided, then, that the exchange rate in the market exceeds, at expiration, the exchange rate entered as the strike price in the terms of the contract, the holder will be able to successfully exercise the contracts terms.
Example
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To illustrate, suppose an investor, Steve, holds U.S. dollars (USD) on January 1st and strongly believes that the exchange rate for dollars into U.K. pounds sterling (GBP) will rise in six months. Steve purchases a GBP/USD call option with a strike price of $1.60 per £1.00 and and an expiration date of June 30th (six months out). If Steve's suspicion is confirmed, and the GBP/USD exchange rate rises to $2.00 per £1.00 on June 30th, then he may exercise his rights and purchase GBP at $1.60 instead of $2.00 and earn an additional $0.40 per £1.00, should he choose to resell.
Considerations
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Currency call options allow investors to speculate on exchange rates with minimal risk. In this regard, such items are highly popular and recommended among investors who hold foreign currencies as part of their investment portfolio or securities (e.g., stocks and bonds) issued by foreign, or offshore, companies and governments. In such cases, currency call options may be used as a buffer against volatility in the foreign exchange market, which might otherwise affect the value of an internationally-diversified portfolio.
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