In this chapter we apply the general price theory to deriving basic pricing formulas for currency derivatives. A currency option, as the name suggests, is an option to do with risk of two or more different currencies. Since the value of a currency is determined by its exchange rate, the term “currency options” is usually used synonymously with term “exchange rate options” or “options on exchange rate.” Currencies options are often used by import and export companies to hedge their risk in foreign exchange exposures. For example, if a company needs to pay a certain amount in a particular foreign currency at a given time in future to settle a trade, it can buy a call option on the currency maturing at that given time to hedge against its appreciation.
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