A Foreign Currency Option is like an insurance policy. It is a "hedging tool" that lets you exchange one currency for another on a given date, at a prearranged exchange rate (strike price), without obliging you to do so. Like forward contracts, foreign currency options eliminate the spot market risk for future transactions. Unlike forward contracts, they do not oblige you to deal if the spot rate is more favourable than your option's strike price. As the name implies, you have the option to deal or not. European-style options let you exercise the option on the expiry date only. American-style options let you exercise at any time from the date of purchase until expiry.
Here's How Options Work:
- There are two types of option contracts--Puts and Calls. Respectively, purchasing these gives you the right to sell (put) or buy (call) a certain amount of a specified currency at a specified strike price for a stated length of time.
- A Canadian Dollar Put, for instance, lets you sell Canadian dollars (and buy U.S. dollars) at a prearranged strike price. You would purchase this option if you are
concerned about an increase in the value of the U.S. dollar. A Canadian Dollar Call
lets you buy Canadian dollars (and sell U.S. dollars) at a prearranged strike price. You would purchase this option if you are concerned about an increase in the value of the Canadian dollar.
- As well as Canadian dollar options, you can also buy foreign currency options in minimum amounts of $100,000 U.S. TD offers over-the-counter options with amounts, strike price and expiry dates tailored to your needs.
- As with any insurance, buying an option involves an up-front cost or "premium." This is determined by the strike price, the expiry date and the volatility of the specified currency at time of purchase. Generally, the premium is higher the longer the term, the closer the strike price to the actual market price and the more volatile the market. You pay no other transaction costs or commissions.
For Exporters:
- If your company exports goods to the U.S., you need to buy Canadian dollars (sell U.S. dollars) to convert your U.S. receivables. If the Canadian dollar rises in value, you will lose money. Purchasing a Canadian Dollar Call option can protect you against this because it lets you know with certainty the highest price you will have to pay to buy Canadian dollars. Of course, you can still take advantage of a cheaper Canadian dollar over the term of the option by buying Canadian dollars in the spot market, if there is a favourable exchange rate movement.
For Importers:
- If your company imports goods from the U.S., you will need to sell Canadian dollars (buy U.S. dollars) to pay these U.S. bills. If the Canadian dollar falls in value, you will lose money. Purchasing a Canadian Dollar Put option can protect you against this because it lets you know with certainty the highest price you will have to pay for U.S. dollars. And, you still can take advantage of a cheaper U.S. dollar over the term of the option by buying U.S. dollars in the spot market, if there is a favourable exchange rate movement.
For more on how TD can work with you to manage your cash, foreign exchange and interest rate risk, review About TD Financial Management Services. Or, if you have a specific question, e-mail us and a TD Treasury representative will follow-up directly with you.
