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Definition: Foreign Exchange Option
Foreign exchange option is a contract which gives owner the right, but not the obligation, to buy or sell a specified amount of one currency in exchange for another currency at a pre-agreed exchange rate, settlement date.
It is also known as currency option of FX option. There are two Foreign exchange options available: Put and Call. A call option gives right to buy and the put option gives right to sell.
For example, an option to buy US dollars for Indian rupees is an USD call and an INR put. Conversely, an option to sell USD for INR is an USD put and INR call. Let’s say an investor expects USD/INR exchange rate is going to increase (Dollar will become more expensive for Indian Investor) in future. In this case, he would like to exercise USD call option. He would buy the dollar at pre-agreed rate which was lower and sell the dollars at higher rate in spot market, thus making some profit.
FX Options allow individuals and firms to hedge against the risk of wide fluctuations in exchange rates.