Advanced Financial Management · Foreign Exchange Exposure and Risk Management

Currency Options for CA Final AFM: Payoffs, Premium and Hedging

Q: How do I calculate the payoff of a currency call and put option?

For the buyer, call payoff = Max(S − X, 0) − premium and put payoff = Max(X − S, 0) − premium, where S is the spot rate at expiry and X is the strike. Multiply by the quantity of foreign currency. The writer's payoff is the opposite sign.

Q: Currency option vs forward cover: which is better?

Neither is always better. A forward fixes the rate and costs nothing upfront, but you cannot benefit from a favourable move. An option costs a premium but caps your downside and lets you gain if the rate moves your way. Compare the effective rate with the forward rate at different expiry spots.

Q: When do I buy a call and when a put in a hedging question?

Buy a call when you have to buy foreign currency, such as an import payable or a foreign loan repayment. Buy a put when you will sell foreign currency, such as an export receivable. Decide from your cash flow, not from your view on the exchange rate.

Q: Is a straddle a hedge?

Not for a known payable or receivable. A long straddle gains when the rate moves sharply in either direction and loses the total premium if it stays near the strike. It is a volatility strategy.

Updated 5 October 2026 · Fact-checked

A currency option gives you the right, not the obligation, to buy (call) or sell (put) foreign currency at a fixed strike rate on expiry, for an upfront premium. To solve: use a call for payables and a put for receivables, find the effective rate after premium in each exchange rate scenario, then compare with forward cover.

Understand Currency Options

A currency option is a contract. The buyer pays a premium today and gets a right, not an obligation, to trade a fixed amount of foreign currency at a fixed rate, the strike (exercise) price, on the expiry date. The seller (writer) takes the premium and must perform if the buyer exercises.

A call option gives the right to buy the foreign currency. A put option gives the right to sell it. Remember it from the buyer's view: a call is for buying, a put is for selling.

The main use is hedging. An importer who must pay foreign currency fears the currency getting costlier, so the importer buys a call. An exporter who will receive foreign currency fears it getting cheaper, so the exporter buys a put. The option protects you on the bad side and lets you keep the gain on the good side. A forward contract locks the rate on both sides. That is the core difference.

The price of this flexibility is the premium. It is paid upfront and is lost whether or not you exercise. So always work with the effective rate, which is the strike adjusted for premium, not the strike alone. If the question gives an interest rate, carry the premium forward to the settlement date. If it does not, do not invent one.

Two combinations are examined. A collar buys one option and sells another at a different strike. It cuts the premium cost but limits your gain. A straddle buys a call and a put at the same strike. It pays off from a large move in either direction, so it is a view on volatility, not a hedge for a known payable or receivable.

Key rules to remember

Call buyer's payoff (per unit): Max(S − X, 0) − Premium; S = spot rate at expiry, X = strike. Exercise only if S > X.
Put buyer's payoff (per unit): Max(X − S, 0) − Premium; Exercise only if S < X.
Writer's payoff: Writer's payoff = − Buyer's payoff (before any other positions); The writer's maximum gain is the premium received.
Break-even rate: Call: X + Premium. Put: X − Premium; Below the call break-even or above the put break-even, the buyer's payoff is a net loss.
Importer's effective rate with a call: If S > X: X + Premium. If S ≤ X: S + Premium; The effective rate is capped at X + Premium. Rupee outflow = effective rate × foreign currency amount.
Exporter's effective rate with a put: If S < X: X − Premium. If S ≥ X: S − Premium; The effective rate is floored at X − Premium.
Importer's collar: Buy call at higher strike Xc, sell put at lower strike Xp. Effective rate lies between Xp + net premium and Xc + net premium; Net premium = call premium paid − put premium received. Use the correct sign if the net is a receipt.
Exporter's collar: Buy put at lower strike Xp, sell call at higher strike Xc. Effective rate lies between Xp − net premium and Xc − net premium; Net premium = put premium paid − call premium received.
Long straddle: Payoff = Max(S − X, 0) + Max(X − S, 0) − (Call premium + Put premium); Break-evens: X + total premium and X − total premium.
Option vs forward cut-off (importer, call): Option beats forward when S + Premium < Forward rate, for S ≤ X; If S > X, compare X + Premium with the forward rate directly.

How to solve Currency Options questions

Use this sequence for any currency option question. It keeps premium, strike and direction from getting mixed up.

1Identify your position. A payable in foreign currency means buy a call. A receivable means buy a put. Note the amount and the settlement date.
2List the data: spot, strike, premium per unit, forward rate if given, and any interest rate for carrying the premium.
3Convert the premium into rupees per unit of foreign currency and multiply by the quantity. If an interest rate is given, carry it to the settlement date. If not, ignore interest.
4For each expiry spot rate, decide whether the option is exercised. A call is exercised if S > X. A put is exercised if S < X.
5Compute the effective rate and the total rupee amount for each scenario, including the premium.
6Find the break-even or cut-off spot rate against the alternative, such as forward cover or no hedge.
7For a collar or straddle, compute the payoff of each leg at each spot rate and add them. Then state the minimum and maximum outcome.
8Conclude in one line: which hedge you recommend, why, and the condition under which the other would be better.

Quickest way: Effective rate table in three lines

When to use it: Use when the question gives two or three expiry spot rates and asks for the net outflow or inflow, or asks you to compare with a forward.

Write the decision rule first: importer pays the lower of S and X, plus premium. Exporter receives the higher of S and X, minus premium.
Plug each scenario spot into the rule and multiply by the amount. Do not draw a payoff diagram unless asked.
Find the cut-off: set S + Premium equal to the forward rate for an importer, or S − Premium equal to the forward rate for an exporter. Check that the cut-off lies on the correct side of the strike.

Common mistakes in Currency Options

Ignoring the premium when stating the final rate or amount.
Students focus on the strike and exercise decision, and treat the premium as a separate line item.
Fix: Always show the effective rate. Add premium for an importer and subtract it for an exporter, and then multiply by the quantity.
Buying the wrong option for the exposure, such as a put for an import payable.
The words call and put are confused with up and down moves in the foreign currency.
Fix: Ask what you must do with the foreign currency. If you must buy it, buy a call. If you must sell it, buy a put.
Exercising the option whenever the spot rate differs from the strike.
Students forget the exercise condition depends on the option type.
Fix: Exercise a call only if S > X and a put only if S < X. Otherwise let it lapse and trade at the market rate.
Comparing the option strike with the forward rate instead of the effective rate.
The premium is forgotten in the comparison.
Fix: Compare X + Premium (or S + Premium if the call lapses) with the forward rate. For an exporter, compare X − Premium or S − Premium.
Treating a straddle as a hedge for a known payable or receivable.
Both a call and a put appear, so it looks like complete protection.
Fix: A long straddle only gains from a large move. It loses the full premium if the spot stays near the strike. Say so in the answer.
Getting the sign of the premium wrong in a collar, because one premium is paid and the other received.
Students add both premiums as costs.
Fix: Write premium paid as negative and premium received as positive, then net them before adjusting the rate.

Worked examples

Example 1

Importer case. An Indian company must pay USD 2,00,000 in three months. Spot is ₹83.00. A three-month forward is quoted at ₹83.80. A USD call option with strike ₹83.50 is available at a premium of ₹0.60 per USD. Ignore interest on the premium. Find the rupee outflow with the option if the spot at expiry is ₹85.00 or ₹82.00, and state when the option beats the forward.

Show the solution

Exposure is a USD payable, so the company buys a call at strike ₹83.50. Total premium = 2,00,000 × ₹0.60 = ₹1,20,000.
If spot is ₹85.00: S > X, so exercise the call. Effective rate = 83.50 + 0.60 = ₹84.10. Outflow = 2,00,000 × 84.10 = ₹1,68,20,000.
If spot is ₹82.00: S < X, so let the option lapse and buy USD in the market. Effective rate = 82.00 + 0.60 = ₹82.60. Outflow = 2,00,000 × 82.60 = ₹1,65,20,000.
Forward cover: 2,00,000 × 83.80 = ₹1,67,60,000, regardless of spot.
Cut-off: if the call lapses, S + 0.60 < 83.80 gives S < ₹83.20. For S above ₹83.50 the option costs ₹84.10 per USD, which is worse than the forward. Between ₹83.20 and ₹83.50 the option costs more than the forward.

Answer: Outflow with the option is ₹1,68,20,000 at spot ₹85.00 and ₹1,65,20,000 at spot ₹82.00. The forward costs ₹1,67,60,000. The option is cheaper than the forward only if the spot at expiry is below ₹83.20. The worst case with the option is ₹84.10 per USD, which is ₹0.30 above the forward rate.

Example 2

Exporter collar. An Indian exporter will receive EUR 1,00,000 in three months. The exporter buys a EUR put with strike ₹90.00 at a premium of ₹1.50 per EUR and sells a EUR call with strike ₹94.00 at a premium of ₹1.10 per EUR. Ignore interest. Find the net rupee receipt if the spot at expiry is ₹87.00, ₹92.00 or ₹96.00.

Show the solution

Net premium paid = 1.50 − 1.10 = ₹0.40 per EUR. Total = 1,00,000 × 0.40 = ₹40,000.
Spot ₹87.00: the put is in the money, so the exporter sells at ₹90.00. The call lapses. Effective rate = 90.00 − 0.40 = ₹89.60. Receipt = ₹89,60,000.
Spot ₹92.00: the put lapses and the call lapses because 92 is below 94. The exporter sells at spot. Effective rate = 92.00 − 0.40 = ₹91.60. Receipt = ₹91,60,000.
Spot ₹96.00: the buyer of the call exercises, so the exporter delivers EUR at ₹94.00. The put lapses. Effective rate = 94.00 − 0.40 = ₹93.60. Receipt = ₹93,60,000.
Range: the receipt per EUR lies between ₹89.60 (floor) and ₹93.60 (cap).

Answer: Net receipt is ₹89,60,000 at spot ₹87.00, ₹91,60,000 at spot ₹92.00 and ₹93,60,000 at spot ₹96.00. The collar guarantees at least ₹89.60 per EUR and gives up any gain above ₹93.60 per EUR, in return for a net premium of only ₹0.40 per EUR.

Exam tips

Write the effective rate for each scenario in a small table. Examiners award marks for each scenario, and it shows the premium was included.
State the exercise condition in words before computing. For example, say the call is exercised because the spot ₹85.00 exceeds the strike ₹83.50.
If the question gives a premium in foreign currency or in percentage, convert it into rupees per unit at the stated spot before you start.
When asked option versus forward, always give the cut-off spot rate and a one-line recommendation that depends on your view of the rate.
In collar and straddle questions, show the payoff of each leg separately and then add them. This protects your marks if the final figure has an arithmetic slip.

Practice questions from Foreign Exchange Exposure and Risk Management

Currency Options 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: frequently asked questions

How do I calculate the payoff of a currency call and put option?

For the buyer, call payoff = Max(S − X, 0) − premium and put payoff = Max(X − S, 0) − premium, where S is the spot rate at expiry and X is the strike. Multiply by the quantity of foreign currency. The writer's payoff is the opposite sign.

Currency option vs forward cover: which is better?

Neither is always better. A forward fixes the rate and costs nothing upfront, but you cannot benefit from a favourable move. An option costs a premium but caps your downside and lets you gain if the rate moves your way. Compare the effective rate with the forward rate at different expiry spots.

When do I buy a call and when a put in a hedging question?

Buy a call when you have to buy foreign currency, such as an import payable or a foreign loan repayment. Buy a put when you will sell foreign currency, such as an export receivable. Decide from your cash flow, not from your view on the exchange rate.

Is a straddle a hedge?

Not for a known payable or receivable. A long straddle gains when the rate moves sharply in either direction and loses the total premium if it stays near the strike. It is a volatility strategy.