Over the Counter (OTC) Currency options are defined as bilateral contracts, the value of which is derived from the value of the underlying asset or security.
A derivative covers any transaction where there is no movement of principle, and where the price performance of the derivative itself is driven by the price of the underlying asset.
The Foreign Exchange offers 3 types of derivatives:
1. Currency options
2. Forex futures
3. Swaps and forwards
Foreign Exchange derivatives can be traded over the counter or on organized exchanges. On exchanges fixed and prescribed contracts are bought and sold. An over the counter derivative instrument is tailored to a customer’s specifications regarding the specific dates, currencies and amounts.
One of the main differences between exchange traded currency derivatives and over the counter currency derivatives, is the credit risk. In the OTC Market each party takes on the risk of the other party. On an exchange, the exchange’s clearinghouse covers the parties’ risk. On the over the counter market, because of the very specific contract details, liquidity may be very low.
A Currency option gives the holder the chance to fix the rate of exchange that will apply to a future exchange transaction. The Option writer (the seller of the option) must guarantee the rate chosen by the holder. For this guarantee a fee is charged. The holder of the option has all the rights implicit to the option but only one obligation, and that is he/she must pay the fee.
The Option writer or seller has all of the obligations, but no rights. In return for the fee he/she must have the underlying currency on hand in case the holder chooses to exercise his/her option.
Currency options can also be exercised at expiry or they can be sold back or sold on at any time during the duration of the transaction for fair value, which depends on the underlying currency price movements.
Currency options are more flexible than traditional outright foreign exchange transaction, and they give the holder several alternatives, such as, whether to exercise the option, when to exercise the option, how much to exercise, and at what price to exercise.
A Forex Carry Trade Explained – https://www.mastersofmoney.com/aforexcarrytradeexplained/
Risk disclosure: *All investments involve risk. Before making any financial or investment decisions, we highly advise that you seek the advice of a properly licensed and trained investment professional.