08 Sep Accounting For Option Agreement
Options are used to allow investors to speculate on both positive and negative movements in securities, either to manage the risk of adverse financial market conditions and to possibly offset losses. Financial institutions such as banks offer online services for trading standard option contracts (stock options, commodity options, bond options, stock index options, futures contract options, etc.) on national foreign exchange markets. London International Financial Futures and Options Exchange (LIFFE), Chicago Board Options Exchange (CBOE). In the case of non-standard options tailored to the specific financial needs of companies, these are called OVER-the-counter options or “trading options” and developed and subscribed by large financial institutions such as investment banks and not on an open exchange. OTC options are primarily used as solutions to hedge risks related to company-specific risk scenarios. Typical OTC options are interest rate options, foreign exchange options, and swap options. Interest rate options allow companies to set predetermined upper (cap) and lower (floor) limits for a set period of time. The buyer of the option pays a premium in advance for the ceiling/floor and gets a maximum/minimum interest rate over a given period of time. If the interest rate exceeds the cap/float rate, the author (bank) pays the buyer a cash amount based on the difference between the actual interest rate and the cap rate for the amount indicated in the option. The upper and lower options can also be combined to create a “col” that ensures that variable interest rates are kept within these limits.
Necklaces include the simultaneous purchase of a ceiling and the sale of a floor by companies that borrow, or the purchase of a floor and the sale of a ceiling if they protect an investment. They can thus benefit from favourable interest rate movements between the “Collar” rates (Cap and Floor) while being protected against unfavourable movements outside these limits. Foreign exchange options are options that are added to FX futures. When the option expires, users have the choice whether or not to exchange currencies at the specified futures price. The following example shows how to combine different positions in the foreign exchange options to hedge and/or take advantage of currency movements….