What Is an Average Rate Option?

John Lister

An average rate option is an options contract based on currency rates over a period of time. This contrasts with most currency options that are based on the price on a specific date. The main use of an average rate option is to minimize the risk of losses caused by currency fluctuations.

Currency rates over a period of time are reflected in an average rate options contract.
Currency rates over a period of time are reflected in an average rate options contract.

An options contract is an agreement between two parties. The first party pays a fixed fee, or premium, to the second party. In return for this payment, the first party has the right but not the obligation to carry out an exchange at a future date. Naturally it will only do so if circumstances mean the exchange is to its benefit.

The simplest form of options contract related to currency exchange rates is for the option to involve a currency exchange at a fixed rate on a future date. When that date comes, the party with the option to make the exchange will usually look at the actual market exchange rate to decide if it is worthwhile exercising the option so that it can make an immediate profit. Some more complicated versions of a currency option allow the first party to exercise the option at any time up to the agreed date, not just on the date itself. As this increases the chances the first party will be able to exercise the option at a favorable rate, the premium payment will usually be higher with this type of deal.

Not all people or organizations that use currency options do so as a form of speculation. A business that deals with overseas clients will often use a currency option as a form of hedging. For example, if a business is supplying an order to an overseas client and is scheduled to receive payment in six months time in a foreign currency, it will be uncertain how much that money will actually be worth in domestic currency when it is received. Using a currency option can protect the business against the currency rate moving in an unfavorable way in the meantime. The business will consider the premium a price worth paying to remove uncertainty and risk.

The average rate option works in a slightly more complex way, and is usually carried out between a business and a bank. Under the average rate option, the business pays a premium and designates a sum of money, an exchange rate and a future date. On this future date, the bank calculates the average actual exchange rate over the period of the contract. If the actual rate is lower than the designated rate, the bank pays the business an amount. This amount is equivalent to effect the difference between the average and designated rate would have on the designated sum.

Although the concept of an average rate option is more complex, from the perspective of the business it appears simpler. This is because there is no need to actually buy or sell any currency: the business pays a premium, and then either gets a cash payment at the end of the period if the exchange rate has been lower than expected, or no money changes hands if the exchange rate has been as expected or higher. In effect, the option simply acts as an insurance policy, paying out if exchange rates are undesirably low.

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