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Currency option transaction

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Currency option transaction (FX OTC option) is a transaction giving the option purchaser, who has paid a fixed premium to its seller, the right, but not the obligation, to buy or sell a fixed amount of foreign exchange at a fixed price per unit in the future. Premium depends on the chosen currency pair, the exchange rate, the transaction term and other factors and must be paid on the transaction date. This transaction is suitable if you do not know precisely whether the planned payment will take place (e.g. when participating in tenders, etc.), but you wish to reduce the risk in advance.

Basic terms of transaction

  • Transaction gives the right, but not the obligation, to exchange currency
  • The minimum transaction amount is EUR 40,000
  • A transaction fee (premium) is payable

Examples

The company takes part in the tendering procedure for the provision of services. The winner will be paid in US dollars. Without being aware of the results of the tendering procedure, the company concludes a FX OTC option, i.e. it agrees with the bank to sell US dollars against euros at the rate of 1.30 US dollar for euro after three months. The company pays a premium at the rate of 2% on the transaction amount for this service.

Scenario No 1
The company has not been awarded a contract in the tendering procedure, and therefore, it refuses to perform a FX OTC option contract.

Scenario No 2
The company is awarded a contract in the tendering procedure after three months. At that time, the US dollar exchange rate stands at 1.35. The company has concluded a FX OTC option contract; therefore, it exercises its right to sell US dollars at a more favourable rate of 1.30.

Scenario No 3
The company is awarded a contract in the tendering procedure after three months. At that time, the US dollar exchange rate stands at 1.25. Under the terms and conditions of the concluded FX OTC option contract, it is not profitable to sell the currency (at the rate of 1.30); therefore, the company refuses to complete this transaction and sells US dollars at the rate of 1.25 by executing foreign exchange spot transaction. The company will not be refunded the paid premium at the rate of 2%.

Risks

After an option has been acquired, the paid premium is not refunded. In case the option is sold, one is exposed to the risk of incurring losses that exceed the received premium in the future as a result of adverse changes in the currency value. The seller of an option undertakes to buy or sell the currency at a pre-agreed rate, which may be unfavourable to the seller and greatly differ from the market price of this currency applicable at that time. If the seller of an option has such currency, he is exposed to lower levels of risk. In case the seller has no currency, the risk might be high; therefore, only experienced market participants should consider the possibility of concluding this type of options. Before concluding the transaction, all the terms and risks of the transaction must be assessed. Options are concluded over-the-counter; therefore, it may be hard to determine the market value of the option — it is not always possible to find the purchase and selling prices of an option and to sell an option on the market or to close it by an offsetting option transaction.

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Markets in Financial Instruments Directive

The Markets in Financial Instruments Directive (MIFID) regulates the rendering of financial investment services has been effective in the European Union and the European Economic Community (EEC) since 2007. The requirements of MiFID are aimed to provide additional protection to investors and promote the transparency of financial markets in terms of transactions in financial instruments.

After 3rd January 2018, new rules of the Markets in Financial Instruments Directive 2014/65/EU (MiFID II) came into force and affect each investor who engages in transactions in financial instruments.

 

Please note that the data, examples and information on derivative financial instruments provided herein is for informational purposes only. This information has been prepared without consideration or regard of your knowledge or experience related to specific financial instruments and without having any information about your investment objectives or financial capacity to assume risks related to the conclusion of the transaction that meets your investment objectives; therefore, it cannot be construed as a personal investment recommendation, advice on trading in derivative financial instruments or investment research, order or invitation to buy or sell specific financial instruments and may not constitute any basis or part of any subsequent transaction.