The salient features of option contracts and the exchange control regulations relating to option contracts in India are discussed below.
Option Contracts. The option contract confers on the buyer the eligibility to buy or sell a sum of foreign currency at a pre-determined rate on a future date, with the right to him to choose not to exercise his entitlement. Essentially, an option contract is a forward exchange contract whereby the future payment/receipt in a foreign currency is sought to be firmed up with regard to exchange rate in terms of the local currency.
The difference between the forward contract and the option contract is that, under the forward contract, the customer is expected to deliver/receive the foreign exchange on the due date at the forward rate irrespective of the spot rate prevailing. Under an option contract, on the due date, the customer can make a reassessment of the situation and seek either the execution of the contract or its non-execution as may be advantageous to him.
Terminology in Option Contracts
The important terms used in connection with option contracts are:
(i) Option buyer—Holder of the right under the contract either to sell or buy one specific currency against another specific currency.
(ii) Option seller—Writer of the option who should deliver or accept delivery of the currency concerned when the right is exercised by the option buyer.
(iii) Call option—A contract under which the option ‘buyer’ has the right to ‘buy’ the specified currency.
(iv) Put option—A contract under which the option buyer has the right to ‘sell’ the specified currency.
(v) Strike price—The exchange rate at which the currencies are agreed to be exchanged under the contract.
(vi) Premium—This is the option price or the fee payable by the buyer of the option to the seller at the time of entering into the contract. This is not refund-able whether the buyer ultimately exercises his right or not.
(vii) Maturity date—The date on which the contract expires.
(viii) American option—under an American option, the option buyer can exercise his right on any date during the currency of the contract, i.e., any date on or before the maturity date.
(ix) European option—Under a European option, the buyer can exercise his right only on its maturity date.
An exporter, for instance, who expects to execute the contract and receive foreign exchange after six months may enter into a ‘put option’ for six months which entitles him to sell the foreign currency on maturity at an agreed predeter-mined price (strike price). If, on maturity, the spot price for the currency is more favourable to the exporter he may choose not to exercise his right of selling under the contract. He can instead sell in the market at the spot rate.
Similarly, an importer may cuter into a ‘call option’ entitling him to buy the foreign currency on a future time. Option contract is useful especially in covering exchange risk under contingent conditions like when the company enters a bid. The exchange risk will arise only if the contract is awarded and foreign currency exposure arises.
Option contracts in India
In India banks are allowed to wnte cross-currency options, after obtaining general permission from Reserve Bank. Options should be sold to customers only to cover their genuine exposures. Only cross-currency options are permitted. That is, both the currencies involved are foreign currencies, e.g., US dollar against Deutsche mark. Options in a foreign currency against Indian rupee is not permitted.