Vanilla Options
Buyer Option
Vanilla options are an agreement between two parties that gives the buyer of the option (which will be you in almost all circumstances), 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.
How vanilla options work
The buyer of a vanilla option nominates the currency pair, expiry date, notional amount and strike rate. Currency Hedger will calculate a premium payable by the buyer of the vanilla option. The premium is payable within two business days unless you select a deferred premium.
A deferred premium option is one that is settled at a date beyond the usual two business days (typically upon expiry of the contract). Please note that deferred premium vanilla options are not available to all Currency Hedger customers.
Upon expiry of the vanilla option, the buyer will either exercise their right to transact, or will allow the option to expire worthless. More details of how this works are below:
- If at the expiry date, the prevailing spot rate is less favourable than the strike rate of the option, it will be more advantageous for the buyer of the option to exercise his right to transact at the strike rate. Currency Hedger allows customers to trade offsetting FX transactions to close in the money option positions in the event that the underlying exposure, and therefore the need to transact, has ceased.
- If at the expiry date the prevailing spot rate is more favourable than the strike rate of the option, it will be more advantageous for the buyer of the option to allow the option to expire worthless. This is because the spot rate will provide a better rate of exchange than the option’s strike rate
The premium is to be paid in full and by the premium due date detailed in the trade confirmation. Furthermore, settlement of an exercised option is required within two business days of expiry.
Vanilla options example:
A UK-based company imports materials from the US and needs to pay a supplier $500,000 in six months’ time.
1. Requirements
The company: 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 1.3300
3. Solution
The company buys a vanilla option for six months with a protected rate of 1.3250. The premium is 2.5%
There are two possible scenarios
Scenario 1:
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.
Scenario 2:
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 vanilla options
- Vanilla options provide protection against adverse movements in the exchange rate of the currency pair during the term of the contract.
- The buyer of a vanilla option is under no obligation to exchange currencies, and is therefore able to participate in all favourable exchange rate movements.
- Vanilla options are not subject to Currency Hedger’s margin call policy, as bought vanilla options cannot carry a negative mark-to-market value.
- As the buyer of the option can select the strike, expiry and notional amount, vanilla options can be tailored to the exact needs of the buyer
Disadvantages of vanilla options
- A non-refundable premium is payable upon the purchase of a vanilla option.
- At expiry or upon cancellation of a vanilla option, movements in the underlying exchange rate for the dealt currency pair, as well as the passage of time, could result in the option having a reduced value or no value at all.
- The total cost of transacting (the cost of the currency plus the premium) might be more expensive than the equivalent forward contract or other hedging product. The total cost (also known as the effective hedge rate) should be considered before entering into a vanilla option.
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