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Definition: Foreign Currency Option
Foreign currency option, also called currency option, is a derivative option with currency as the underlying asset. It gives one party the right, and other party an obligation, to exchange one currency for another at a predefined time with a predefined exchange rate.
A foreign currency option between two parties is formulated where party A (buyer of option) exchanges 100USD with party B for Rupees at an exchange price of Rs.50 per USD on July 30, 2012. If on July 30,2012 the exchange rate is Rs.45 per USD, party A will execute its right and earn the difference Rs.5(Rs50-Rs.45)*100 = Rs.500. If on July 30, 2012 the exchange rate is Rs.55 per USD, party A will not execute its right and simply lose the premium it paid to enter into the contract.