Businesses that deal with foreign currency average rate options to pay or receive money in foreign currencies. These options give businesses a hedge against potential fluctuation in prices of foreign currencies. Today we will look at everything you need to know about ARO (average rate option) and its importance in the Forex market. Let us dive right in without further delays.
Average Rate Option: Meaning and Definition
Average rate option falls under the category of what we call currency exchange derivative product. It is a tool primarily used by traders to hedge against unpredictable falls in the value of foreign currencies. Average rate options' strike price is determined by averaging spot rates through the course of the option at the time of maturity. Let us explore the average rate option in detail with a focus on its opportunities, risks, and variations.
What Is an Average Rate Option?
An average rate foreign exchange (FX) option is a technique for managing FX exposure. It can shield you from negative currency swings. A worst-case foreign exchange rate can be obtained for a future transaction on the payment of an upfront fee. The name given to this rate is Strike Rate. The customer receives a cash pay-out if the Average of a predetermined number of foreign exchange fixes is greater than the Strike Rate on the expiration date. This is because average rate options are always settled in cash. The option expires and becomes worthless if the average of the already set number of foreign exchange fixes is equal to the Strike Rate or lower than it.
Businesses that must regularly deal with foreign currencies use this currency exchange derivative product. Let us find out more about how it works, who uses it, and its risks and benefits. Because of the changing strike price, average rate option is also referred to as an exotic option rather than a regular option. Since the option of exercising the right to sell or buy the asset is confined to the date of its expiry, it is also recognized as a form of European option.
How Does the Average Rate Option Work?
A buyer and seller commit to foreign exchange currency options at a defined strike price on an already decided schedule to begin trading in average rate options. The option comes at a premium cost. The buyer will acquire the identical currency pair on the market with a specific maturity date during the already decided time limit. The striking price is then measured against the average price of the currency pair during the contract period at the date of expiry. The seller then must pay the buyer the difference if the average price is less than the strike price. The option is useless if the price is higher.
The deduction between the present FX spot rate, previous fixes, and the FX spot rate at the time of the trade would decide the Early Termination cost. The gap between the market's present state of FX volatility and the market's FX fluctuation at the time of the trade. Average Rate Options, like most options, are intended to be used as risk management instruments and held until the expiration date.
Who Purchases the Average Rate Option?
Enterprises that trade overseas frequently employ average rate options. They bear the brunt of pricing swings since they must pay or receive payments in a different currency. A US company, for example, might contract to purchase raw materials from a Chinese source for a year and pay the provider in the Chinese currency - the yuan. Let us assume 70,000 yuan is the set amount to be paid every month. The risk for American businesses is that the Chinese currency may appreciate against the dollar. It would result in cost increases and the contract's revenues would be lost.
The company pays the vendor 70,000 yuan purchased on the spot market at every month’s end. Once the ARO matures, the strike price is then calculated against the average rate paid by the company for the transaction of 50,000 yuan. Only if the average price is less than the strike rate will the company execute the option, and the issuing party then must pay the company the deficit between the average price and strike price.
Opportunities and Risks of Average Rate Option
As with most options, there are both risks and opportunities in Average Rate Option. In terms of benefits and opportunities, ARO protects against unfavorable FX movements that are higher than the Strike Rate. It also aids in the calculation of the worst-case FX rate for FX transactions. Apart from that, Average Rate Options allow you to profit from advantageous exchange rate changes. It also makes it easier to sell the option at the spot price if future FX coverage is no longer needed.
In terms of risks, there are two main pointers. Since an Average Rate Option is a one-time payment by the client, it lowers the value of the product and is omitted in the event of an unutilized option. The option's price may also depreciate before it matures. Early termination of the option might not even result in a full or partial refund of the initial price.
What Are Other Average Options?
There are additional average solutions that also exist to protect against other market risks. For instance, Average strike options are widely used to hedge a stock's price fluctuations over a particular timeframe. Average rate options are exchanged on non-standardized markets as exotic options. They are not traded on any regulated stock exchanges. As a result, the most frequent users of these options are institutional investors. It scarcely benefits retail investors.Through complex contracts and clauses, institutional investors can also construct and coordinate average rate options. It also gives protection against replacement risk.
We hope this brief guide will help you better understand the concept of the average rate option and how it works in real scenarios.