Derivatives | Cross Currency Option

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Acash-settled option that entails the exchange of one currency into another with the premium usually paid in a third currency. In other words, the currency of the strike price of this option is different from the currency used to denominate the underlying asset. A simple example is a call option to purchase Euro 100 at a strike price of US$ 1.2. If the price of Euro is in US dollars, the option would be nothing than a regular option. However, if the price of Euro is measured in Australian dollars, while the strike price is in US dollars, then the option is a cross-currency option. As a result, the price of this cross-currency

option is based on both the Australian dollar value of the Euro and likewise on the Australian dollar value of the US dollar.

This option is particularly used by firms which have cash flows denominated in two different currencies, neither of which is the domestic currency. For example, an American company that outsources it inputs from Europe and markets its final products in Australia, is not only exposed to the Euro/US dollar and US dollar/AUS exchange risks, but also it has an exposure to the value of the Australian dollar of the US dollar. To hedge these foreign exchange risks, the company would buy OTC cross-currency options from banks or financial institutions.

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Category: Options

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