Late last year we started a series of educations posts relating to the fundamentals of currency hedging. This latest post covers the basic workings of Average Price Currency Options.
The currency markets are volatile markets in which movements between currency pairs can be swift and choppy, changing the direction during political uncertainty or during statement by central banks on monetary policy. Many treasurers have significant exposure to the currency markets, and hedging using daily operating currency rates can be a significant help in smoothing a corporation’s cash flows.
Average Price Currency Options
An average price option, which is also known as an Asian option, is a financial instrument in which the payout is calculated based on the average price through a specific period. The period in question can range from a couple of days to multiple years. Average price options help a treasurer hedge their exposures to the currency markets on a daily basis, removing the daily volatility associated with currency fluctuations.
Average Price Option Payout
Average price currency options generate a different payout profile when compared to European and American style options. An average price option is calculated by averaging a specific currency rate either using the end of the day price or a mutually agreed upon point, over the period in which the option is active. For example, a monthly average price option would use the daily average of the trading days during the month. This level is compared to the strike price, and the difference when multiplied by the volume generates the payout.