Average rate currency options are based upon the average exchange rate of the underlying currency as distinct from the exchange rate on a single date — the expiry date.

The advantage of an average rate option is that the volatility of a moving average of a variable is less than the volatility of individual observations of that same variable. With daily observations, and with the volatility levels seen in the currency markets, the volatility of the moving average is in the order of 60% of that of the raw observations. Consequently, the price of an average rate option with a given exercise price will be less than an otherwise identical standard European currency option.

Average rate options are available from the OTC market, are European in form and cash settled. The majority have fixed exercise prices and the asset price (currency rate) is averaged. However, some options have the exercise price set as the average of the exchange rate over time, and the exchange rate at expiry is not averaged. These options are known as floating strike options. Average rate options where the exercise price is fixed are the most common. The option contract must specify the source and the frequency with which the exchange rate will be observed during the life of the option. The market practice is to calculate the arithmetic mean of the exchange rate; however, early average rate option models assumed a geometric mean of rates.

In the currency options markets, these options are developing a following because they genuinely provide an economic service. They provide insurance against losses, on a periodic stream of cash flows, caused by the exchange rate falling below (for puts) or rising above (for calls) an average rate for the whole period.

For example, a company may have a regular stream of currency receipts or payments, and in the budgeting process assumes an average rate of exchange over the accounting period. Some cash flows will be exchanged above the budgeted rate, while others will be exchanged below it.

In order to insure against the exchange rate falling below this average level, there is a choice between buying options with specific expiry dates that match the periodic cash flows, and exercise prices set to match the average. Alternatively, a single put option can be purchased, with an amount covering the total cash flows, an expiry equal to the date of the final cash flow and an exercise price equal to the average of the periodic exchange rates — an average rate option.

As the pricing of the average rate option will be based upon the volatility of the moving average of the exchange rates, it will therefore be cheaper than a standard currency option. Yet over the entire period of the strategy, it will provide the same level of insurance as a more expensive standard option with a similar exercise price.

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