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Financial Management · Hedging techniques for foreign currency risk

Currency Options and Currency Swaps for ACCA FM

Updated 11 October 2026 · Fact-checked

A currency option gives you the right, not the obligation, to buy or sell currency at a fixed strike rate, in return for a non-refundable premium. You exercise only if the strike beats the spot rate. A currency swap exchanges principal and interest payments in two currencies to fix borrowing costs.

Understand Currency Options and Currency Swaps

A currency option protects you against a bad exchange rate but lets you keep the benefit of a good one. You pay a premium upfront for this. The premium is lost whether or not you use the option.

A call option is the right to buy the foreign currency at the strike (exercise) price. A put option is the right to sell it. If you must pay foreign currency later, you want to buy it, so you buy a call. If you will receive foreign currency, you want to sell it, so you buy a put.

At expiry you compare the strike rate with the spot rate. If the strike gives you a better deal, you exercise. If spot is better, you let the option lapse and deal at spot. Either way, the premium is part of the total cost. This is the key difference from a forward contract. A forward locks in one rate and you must deal at it, so you lose any favourable move. An option sets a worst-case rate and keeps the upside, but costs a premium.

A currency swap is an agreement between two parties to exchange principal in two currencies at the start, pay each other's interest during the term, and swap the principal back at the end at the same rate. It is used for longer-term exposures, such as a foreign loan or a foreign subsidiary's funding. It lets a company effectively borrow in a currency it needs, often at a better rate than it could get directly, and it fixes the exchange rate for the whole term.

In the exam, options are usually tested with calculations (total cost or receipt at different spot rates). Swaps are tested with a small calculation of the cash flows and with explanation of benefits and risks.

Key rules to remember

Which option to buy
Paying foreign currency → buy a call on the foreign currency. Receiving foreign currency → buy a put on the foreign currency.
Think about what you need to do with the foreign currency. Pay it means you buy it (call). Receive it means you sell it (put).
Exercise decision
Call: exercise if spot > strike. Put: exercise if spot < strike.
Spot and strike are both quoted as home currency per unit of foreign currency. If they are equal, you are indifferent.
Premium cost
Premium = foreign currency amount × premium per unit
Premium is paid at the start and is non-refundable. Ignore interest on it unless the question tells you to include it.
Total cost of a call hedge (paying foreign currency)
Total cost = amount × lower of (strike, spot) + premium
Worst-case effective rate is the strike plus premium per unit.
Total receipt of a put hedge (receiving foreign currency)
Total receipt = amount × higher of (strike, spot) − premium
Worst-case effective rate is the strike minus premium per unit.
Break-even against a forward (call, paying foreign currency)
Break-even spot = forward rate − premium per unit (valid only when this is below the strike)
The option is cheaper than the forward if spot at expiry is below the break-even spot. The forward is cheaper if spot is above it.
Currency swap mechanics
Start: swap principals at spot. Term: each party pays interest on the principal it received, in that currency. End: re-swap principals at the same spot rate.
The end exchange is at the original rate, which is why the exchange rate risk is removed.

How to solve Currency Options and Currency Swaps questions

Use this method for any option or swap question. Set out each step clearly so you earn method marks in Section C and avoid slips in the objective questions.

  1. 1Identify the exposure: are you paying or receiving foreign currency, how much, and when?
  2. 2Choose the instrument: call if you are paying foreign currency, put if you are receiving it. Check the exam wording for the currency pair and which currency the option is over.
  3. 3Calculate the premium: foreign amount × premium per unit. Convert into home currency at the rate given (usually spot) if needed.
  4. 4For each possible spot rate at expiry, compare spot with the strike. Decide to exercise or lapse.
  5. 5Calculate the home currency cost or receipt at the better of strike and spot, then add or subtract the premium.
  6. 6Compare with the forward, money market hedge or no hedge, as the question requires. State which is best and the break-even rate if asked.
  7. 7For a swap: write down the principals swapped, the interest each party pays, the final re-exchange, and the net effect on borrowing cost and risk.
  8. 8Add a short comment: options give a worst case with upside but cost a premium. Swaps fix rates for long terms but carry counterparty risk.

Quickest way: Effective rate shortcut

When to use it: Use in Section A or Section B objective questions where you need the cost or receipt at one given spot rate.

  1. Decide call or put from the direction of the cash flow.
  2. Compare spot with strike. Pick strike if it is better for you, otherwise spot.
  3. Add the premium per unit to the rate for a call (cost), or subtract it for a put (receipt).
  4. Multiply the effective rate by the foreign currency amount.
  5. Check the answer is not better than the option's worst case. If it is, you have used the wrong rate.

Common mistakes in Currency Options and Currency Swaps

  • Buying a put when you should buy a call (or the reverse).

    Students think about the home currency instead of the foreign currency that the option is written over.

    Fix: Ask what you do with the foreign currency. Pay it means buy it, so a call. Receive it means sell it, so a put.

  • Forgetting the premium, or treating it as refundable when the option is exercised.

    The premium is paid before the outcome is known, so it is easy to leave out of the final calculation.

    Fix: Always add the premium to the cost (or deduct it from the receipt) in every scenario, including when the option lapses.

  • Exercising the option when spot is better than the strike.

    Students assume that having an option means using it.

    Fix: Compare strike and spot every time. An option is a right, so lapse it when the market rate is better.

  • Saying an option removes all risk, or that a forward is always cheaper.

    Both are over-simplified from memory.

    Fix: Say the option caps the worst case, keeps the upside and costs a premium. A forward has no premium but is binding, so it gives no upside.

  • Applying swaps like a forward and ignoring interest payments.

    Students remember the principal exchange but miss that interest in each currency is paid during the term.

    Fix: List the three stages: initial exchange, periodic interest in each currency, final re-exchange at the original rate.

  • Mixing up quote direction, such as $ per € versus € per $.

    Questions may quote either way and students multiply when they should divide.

    Fix: Write the rate with units, such as $1.20 per €1, before calculating. Check the answer is sensible.

Worked examples

Example 1

A US company must pay €800,000 in three months. It buys three-month over-the-counter euro call options with a strike of $1.2000 per €1 and a premium of $0.02 per €1. The three-month forward rate is $1.2150 per €1. Calculate the total dollar cost if the spot rate in three months is (a) $1.25 and (b) $1.15. Ignore interest on the premium. Find the spot rate at which the option and forward cost the same.

Show the solution
  1. Exposure: paying euros, so buy a call option on euros.
  2. Premium = 800,000 × $0.02 = $16,000, paid now.
  3. (a) Spot $1.25 is above strike $1.20, so exercise. Cost = 800,000 × 1.20 = $960,000. Total = 960,000 + 16,000 = $976,000 (effective rate $1.22).
  4. (b) Spot $1.15 is below strike $1.20, so let the option lapse and buy at spot. Cost = 800,000 × 1.15 = $920,000. Total = 920,000 + 16,000 = $936,000 (effective rate $1.17).
  5. Forward cost = 800,000 × 1.2150 = $972,000.
  6. Break-even: when spot is below the strike, option total per € = spot + 0.02. Set equal to 1.2150, so spot = 1.2150 − 0.02 = $1.195. This is below the strike of $1.20, so it is valid. Below $1.195 the option is cheaper than the forward. Above it, the forward is cheaper (the option's cost is capped at $1.22 per €1).

Answer: (a) $976,000. (b) $936,000. The forward costs $972,000. The option is cheaper than the forward only if spot at expiry is below $1.195 per €1.

Example 2

A US company needs €10 million for five years to fund a European subsidiary. The spot rate is $1.20 per €1. It borrows $12 million at 5% a year from its bank. It then agrees a currency swap with a European company. The US company hands over the $12 million and receives €10 million at spot. Each year it pays the counterparty 4% on €10 million, in euros. The counterparty pays the US company the 5% dollar interest on $12 million, and the US company passes this to its bank. At the end the principals are swapped back at $1.20. Show the cash flows and the effect if the spot rate at the end of year 5 is $1.30 per €1.

Show the solution
  1. Start: the US company borrows $12 million from its bank and passes it to the counterparty. It receives €10 million, which it uses to fund the subsidiary.
  2. Each year: the US company pays €10m × 4% = €400,000 to the counterparty. The counterparty pays $12m × 5% = $600,000, which the US company uses to pay the interest on its own dollar loan.
  3. End of year 5: the subsidiary returns €10 million. The US company hands €10 million to the counterparty and receives $12 million back, at the original swap rate of $1.20. It uses the $12 million to repay its dollar loan.
  4. Net effect: the swap receipts of $600,000 a year and $12 million at the end exactly cover the dollar loan. So the company's net liability is €400,000 a year plus €10 million at the end. This matches the euro cash flows of the subsidiary. The swap does not show whether 4% is cheaper than borrowing euros directly, so do not claim a saving unless the question gives comparable rates.
  5. Without the swap, this company has a dollar loan of $12 million but euro-earning assets of €10 million. Assume it has no other dollar funds to repay the loan. It must then convert the €10 million at the spot rate at the end of year 5 to repay $12 million. It is exposed to the euro falling below $1.20. For example, at $1.10, €10 million buys only 10m × 1.10 = $11 million, a $1 million shortfall.
  6. At $1.30, €10 million would buy 10m × 1.30 = $13 million without the swap, a $1 million surplus over the $12 million owed. The swap fixes the re-exchange at $1.20, so in this case the company gives up that $1 million gain. This result comes from hedging a euro asset against a dollar liability. It is not a general rule for every swap. In return the company is protected from a loss if the euro falls below $1.20.
  7. Note the risk: the swap depends on the counterparty performing its obligations, so there is counterparty risk.

Answer: The US company borrows $12 million at 5% and swaps into euros, so the swap fixes the re-exchange at $1.20. Its net liability becomes €400,000 a year and €10 million at the end, matching the subsidiary's euro cash flows. The $600,000 a year and $12 million it receives exactly cover its dollar loan. If the euro rises to $1.30, the company forgoes a $1 million gain it would have made on its euro asset without the swap. If the euro fell to $1.10, the swap would protect it from a $1 million shortfall. The swap also carries counterparty risk.

Exam tips

  • Always state why you chose a call or put in one line. Examiners award marks for the correct choice and the reasoning.
  • Show the exercise decision for each scenario. In an objective test, a wrong decision on exercise gives zero, as there are no partial marks.
  • Check whether the question asks for the cost at a given spot or the worst-case cost. They use different numbers.
  • In discussion parts, compare options with forwards on three points: premium, flexibility and certainty of the rate. For swaps, mention long term, fixed cost and counterparty risk.
  • Ignore interest on the premium unless told otherwise, and say so in your answer.

Practice questions from Hedging techniques for foreign currency risk

Currency Options and Currency Swaps in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Currency Options and Currency Swaps: frequently asked questions

What is the difference between a currency option and a forward contract?

A forward contract fixes one exchange rate and you must deal at it, so there is no premium but no upside. A currency option sets a worst-case rate and lets you use the spot rate if it is better, but you pay a non-refundable premium. Use the option when you are unsure the transaction will go ahead or want to keep the upside.

How do you calculate the outcome of an option hedge with a premium?

Compare spot with the strike at expiry and choose the better rate, exercising or lapsing as needed. Multiply that rate by the foreign amount, then add the premium for a payment or deduct it for a receipt. The premium is included whether you exercise or not.

Do you exercise a currency option every time?

No. An option is a right, not an obligation. For a call, exercise only if spot is above the strike. For a put, exercise only if spot is below the strike. Otherwise let it lapse and deal at spot.

What is a currency swap in ACCA Applied Skills FM?

It is an agreement to exchange principal in two currencies at the start, pay each other's interest during the term and swap the principal back at the end at the same rate. It hedges long-term exchange rate exposure and can lower borrowing costs. Its main risk is that the counterparty defaults.