Average Rate Options
An average rate option (ARO) is an FX derivative by which the buyer and seller commit to exchange FX options at a predefined strike price under a schedule covering the duration of the contract in exchange for a premium price. During this period, the buyer will purchase the currency on the spot market with a defined maturity date and the strike price is compared to the average price of the currency pair during the contract.
If the average price is less favourable than the strike price, the issuer will reimburse the buyer for the difference. However, if the average rate is more favourable, the option will expire worthless.
For instance, a European importer needs to buy USD every month – amounting to a total annual value of $1 million – so as to pay a supplier. In order to hedge against currency volatility, the importer buys an ARO with a strike price of 1.12 that matures in 12 months.
The importer will exchange EUR/USD on the spot market every month and on the maturity date. If the average EUR/USD exchange rate is below 1.12, the issuer will pay the buyer the difference. If the average rate exceeds 1.12, the buyer would have obtained a better rate for their dollars on the spot market. The contract will expire worthless and the buyer will have to pay the issuer the premium price.
AROs are an alternative to reduce FX risk, but they pose some constraints as they do not guarantee the exchange rate and therefore might still lead to significant FX gains and losses. Companies with ongoing and/or variable currency exposure have more efficient alternatives like flexible forwards or Dynamic Hedging.