As with most options, settlement can be physical or in cash, where the cash settlement is the payoff of the option on expiry. Here we have examples of both physically and cash settled FX options. In the first example, if I own a physically settled dollar yen option and I exercise it at expiry, then I enter into a spot ethics trade at the strike price. So in the case of the example, I sell $10 million at a rate of 1.38. Once exercised, as with any physically settled option, I can now stay in the spot trade or I can close it out in the market by buying dollars at the prevailing spot rate.

In the second example, if I own a cash settled version of the same option, then instead of exercising into a spot FX position, I simply receive the cash value of the payoff.

Note that the payoff can be calculated in either the quoted or base currency, and the contract will usually specify what happens here. Even if it settles in the wrong currency, for me, all it takes is a trivial spot trade to convert into the other currency. Usually, if cash settlement is the exercise style, the payoff will be calculated against some agreed reference rate or fixing page, which both counterparties are happy is an independent source of market price information. As with all options, participants will make their choice of physical or cash settlement based on their trade motivations. However, generally speaking, and this is true of options in all markets, financial institutions tend to prefer cash settlement because their motivation is the generation of a payoff and end users. For example, companies hedging their FX risk tend to prefer physical settlement because they have an interest in entering into an underlying foreign exchange trade.