Foreign Exchange Options (FXO’s) give the buyer of an option the right but not the obligation to enter in to a trade to exchange amounts of two currencies at a pre-defined rate at the expiry of the option.
FXO’s are used to diversify or hedge an institution’s FX exposure or to speculate on expected currency moves. The attraction of using options such as an FXO is that capital is not tied up and there are no cash flows, other than the payment of the premium. An FXO is made up of time, strike, spot, implied volatility and forward.
FX Options are European-style options, i.e. they can only be exercised at the expiry date set at the inception of the deal. However an option can be exercised for profit before expiry by simply reversing the trade to the same expiry date (ideally with the same strike/exercise price). Finally, an option can be allowed to expire without being exercised in which case the buyer of the option will have lost the premium agreed at the initiation of the option.
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