OTC (Over the Counter) Currency options are defined as bilateral contracts, the value of which is derived from the value of some 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.
It is especially this aspect (the no movement of principle) that makes Derivatives such useful instruments to hedge other exposures and to do specialized risk management.
Foreign exchange derivatives are the following: • Currency Options • Forex Futures • Swaps and Forwards
Foreign Exchange derivatives can be traded over the counter or on organized exchanges – On organized exchanges fixed and prescribed contracts are bought and sold. An OTC derivative instrument is tailored to customer’s specifications regarding the specific dates, currencies and total amounts involved.
One of the main differences between exchange traded currency derivatives and OTC 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. In the OTC Market, because of the very specific contract details, liquidity may be very low, i.e. it may not be easy or possible to trade with such an instrument if the right party cannot be found.
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 – he must pay the fee.
The Option writer or seller has all the obligations, but no rights. In return for the fee he must have the underlying currency on hand (in stock) in case the holder chooses to exercise his 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. Alternatively they can be physically delivered.
Currency Options is more flexible than a traditional forward outright foreign exchange transaction and gives the holder several alternatives:
• Whether, to exercise the option?
• When to exercise the option?
• How much to exercise?
• At what price to exercise?
This is a very simple and concise explanation of what is OTC Currency Options.