Vanilla foreign exchange options are a type of option that allow two currencies to be exchanged at a pre-authorized date using a pre-determined currency exchange rate. Vanilla foreign exchange options are similar to stock options in the sense the option owner does not have to exercise the right to exchange and can either sell or buy a financial instrument, but different because two currencies are exchanged rather than shares of a single company.
Vanilla foreign exchange currency options are bought and sold via options brokers and implemented on foreign exchanges. The National Futures Association recommends doing so through regulated foreign exchange services such as the Chicago Mercantile Exchange (CME) and the Philadelphia Stock Exchange . Vanilla foreign exchange options are not the same as vanilla forward or swap contracts which follow similar principles, but are not the same financial instruments.
To illustrate how a vanilla foreign exchange option works, Mr. Jones enters into an agreement to sell 10,000.00 Singapore Dollars (SGD)at a specific rate of exchange for U.S. Dollars (USD) at a rate of .7721. If on the date of exchange, the exchange rate between the Singapore Dollar and U.S. Dollar declines, Mr. Jones can still sell the 10,000 SGD at the previous rate making a profit if the difference in exchange rate exceeds the cost of the option.
Depending on which exchange is issuing the vanilla foreign exchange options, the choice to exercise the option may occur either on the expiration date only, or anytime prior and including the expiration date. Like stock options, vanilla foreign exchange options can either be written or purchased. When the currency options are written as a put order i.e. sell for the option purchaser, the writer must pay the difference between the market price and strike rate if the currency exchange devalues, and the buyer must pay the difference if the value of the currency exchange appreciates.
Using the same example as above, suppose instead, that Mr. Jones decides to write the option. In such case he finances the option buyers right to sell the 10,000 Singapore Dollars at an exchange rate of .7721 with the U.S. Dollar. For this, the buyer, Mr. Smith, pays a contract fee that is paid to Mr. Jones. If the exchange rate does not become ‘in the money’ i.e. the exchange rate of the currency pair yields less dollars, then the option expires worthless for Mr. Smith who loses his fee to Mr. Jones.
Volatility risk can be a problem with vanilla foreign exchange options. This volatility increases in proportion to leverage. For example, if Mr. Jones writes a put option for 100,000 Singapore Dollars instead of 10,000 and is using a 10:2 margin rate, then Mr. Jones is 80 percent leveraged at the time of writing the option. If the currency pair becomes in the money beyond the 20 percent, a margin call or additional funds may be required from Mr. Jones to cover the cost of exercising the option at the lower exchange rate regardless of whether Mr. Smith exercise the option. This is so the exchange does not have to cover the cost should Mr. Jones not have the funds to pay the difference between the market and the strike rate at which Mr. Smith sells.
Sources:
1. http://bit.ly/9qQRyn (National Futures Association)
2. http://bit.ly/bRMBwv (MathFinance)
3. http://bit.ly/9tmvZA (Travelex)
4. http://bit.ly/9tmvZA (Yahoo Finance)
5. http://bit.ly/cdJDKV (Federal Reserve)