In simple terms, a currency option is the right to buy or sell an amount of a currency at a pre-determined strike price (here it is an exchange rate) before or on a set expiration date. To understand how this type of option works, suppose a Japanese family is planning to take a vacation in the United States two months later. If the US dollar depreciates during the next two months, the family members can consider eating at fancy restaurants during their journey. That is because their yens will buy more of the weakened dollars when they get there. But, if the dollar appreciates, those folks might be content with having their meals at fast food outlets. Therefore, they face an exchange rate risk. To hedge this risk, they might buy today the right, without being obliged or required, to buy dollars at a specified price two months from now. If they did, they would be buying a “dollar call option”.

Now, if one dollar is worth 90 yens today, locking in that exchange rate might be a good course of action. In exchange for the right, they need to pay a foreign exchange broker a fee (which is of course the option premium or price). The call option on dollar is similar to an insurance policy. Suppose that the exchange rate at the vacation time is 85 yen per one dollar (symbolically quoted ¥/$). That means the yen had appreciated or strengthened, and the option holders would not exercise simply because by walking away from the option, or letting it expire worthless, they get more dollars for their yens. Hence, the insurance policy would not be used, and the fee would be lost altogether. In the other case, if the yen-dollar exchange rate is 95 after two months, that means the option holders would have to pay more yens for one dollar. Then, exercising their right will make them 5 yens better off for each dollar they get. After all, they just pay 90 for what is worth 95. As a result, the insurance policy is better be sought and utilized to protect these vacationing people from unfavorable exchange rate fluctuations.