Hedging Currency Positions (Various Options) - Forex Management

Hedging with Currency Options

Hedging currency has various options such as –with foreign currency options, hedging with currency futures and contracts etc.
Let us now explain each one by one:

Hedging Currency Positions with Foreign Currency Options:
In 1972, the flexible exchange rate system was re established and since then the multinational corporations, international banks and governments have had to deal with the problem of exchange rate risk. Until the introduction of currency options, exchange rate risk usually was hedged with foreign currency forward or futures contracts. Hedging with these instruments allows foreign exchange participants to lock in the local currency values of their revenues of expenses.
However, with exchange-traded currency options and dealer’s options, hedgers, for the cost of the options, can obtain not only protection against adverse exchange rue movements, but benefits if the exchange rates move in favorable directions.
This can be understood with the help of an example.
Suppose a U.S. computer corporation sells one of its mainframe computers to a German manufacturing company for 625,000 DM, with the payment to be made in Deutsche marks by the German company to the U.S. Company at the end of three months. Suppose the current exchange rate is $.40/DM. Thus, if the U.S Company were paid immediately and the marks were converted, it would receive $250,000. Since payment is not due for three months, the US company faces both the risk that the $/DM exchange rate could decrease, resulting in fewer dollars, and the possibility of greater dollar returns if the $/DM exchange rate increases. For the costs of DM put options, the US. Company can protect its dollar revenues from possible exchange rate decreases while still benefiting if the exchange rate increases.

Hedging with Currency Futures and Contracts:
With the following options the foreign currency can be hedged.

  1. By going long in a currency call option, the investor can lock in the maximum dollar costs of a future cash outflow or liability denominated in a foreign currency while still maintaining the chance for lower dollar outlays if the exchange rate decreases. In contrast, by going long in a currency put, the investor can lock in the minimum dollar value of a future inflow or asset denominated in foreign currency while still maintaining the possibility of a greater dollar inflows in case the exchange rate increases. With foreign currency futures and forward contracts, the domestic currency value of future cash flows or the future dollar value of assets and liabilities denominated in another currency can he locked in. Unlike Option hedging, however, no exchange rate gains exist when futures or forward contracts are used.
  2. Hedging Future Currency Cash Flows With A Naïve Hedge Large multinational corporations usually hedge their currency positions in the inter-bank forward market, whereas smaller companies, some portfolio managers, and individuals often use the futures market. Either way, the currency position usually is hedged with a naïve hedging model in which the number of futures or forward contracts is equal to the value of the foreign currency position to be hedged.

To illustrate currency hedging, consider the option hedging example presented above in which a U.S company expected a receipt of 625,000 DM at the end of three months. Instead of hedging with a DM put, suppose the company decides to hedge its receipt with a DM futures contracts expiring at the end of three months, currently trading at Sf =$0.40/ DM when the spot exchange rate is at S0 =$0.40/ DM. Since the contract size on the DM futures contract is 125,000 DM, the company would need to go short in fiveDM contracts, if it uses a naïve hedging approach:

($0.40 / DM) (625,000 DM)
($0.40/ DM) (125,000 DM)

=5

Doing this, the company would, in turn, ensure itself of a $250,000 receipt at expiration when it converts its 625,000 DM to dollars at the spot $ / DM exchange rate and closes its short futures position. If a multinational has a future debt obligation that is required to pay in foreign currency; then it could lock in the dollar cost of the obligation by taking a long futures or forward position. This hedging strategy where the dollar costs of purchasing 625,000 DM at the end of three months is hedged with five long DM contracts priced at Sf=$0.40 / DM. In this case, the net costs of purchasing the Maria on the spot and closing the futures is $250,000, regardless of the spot exchange rate.

Currency Options for whom i.e. who needs Currency Options
Currency options are useful for all those who are the players or the users of the foreign currency. This is particularly useful for those who want to gain if the exchange rate improves but simultaneously want a protection it the exchange rate deteriorate. The most the holder of an option can lose is the premium he paid for it. Naturally, the option writer faces the mirror image of the holder’s picture: if you sell an option, the most you can get is the premium if the option dies for lack of exercise. The writer of a call option can face a substantial loss if the option is exercised: he is forced to deliver a currency-futures contract at a below-market price. If he wrote a put option and the put is exercised, then he is obliged to buy the currency at an above-market price.
Foreign exchange options present an asymmetrical risk profile unlike futures, forwards and currency options. This lopsidedness works in favor of the holder and to the disadvantage of the writer. This is why because the holder pays for it i.e he takes the risk. When two parties enter into a symmetrical contract ;ole a forward, both can gain or lose equally and neither party feels obliged to charge the other for the privilege. Forwards, futures, and swaps are mutual obligations; options are one-sided. The holder of a call has a downside risk limited to the premium paid up front; beyond that he gains one-for –one as the price of the underlying security.
One who has brought p put option gains one-for-one as the price of the underlying instrument falls below the strike price. Traders who have written or sold options face the upside down mirror image profit profile of those who have bought the same options.
From the asymmetrical risk profile of options, it follows that options are ideally suited to offsetting exchange risks that are themselves asymmetrical. The risk of a forward-rate agreement is symmetrical; hence, matching it worth a currency option will not be a perfect hedge. Because doing so would leave you with an open, or speculative, position. Forward contracts, futures or currency swaps are suitable hedges for symmetrical risks. Currency options are suitable in which currency risk is already lopsided, and for those who choose to speculate on the direction and volatility of rates.
Options are not only for hedgers, but also for those who wish to take a “view”. However, for one who is, say, bearish on the deutschemark, a DM put is not necessarily the best choice. One can easily bet on the direction of a currency by suing futures or forwards. A DM bear would simply sell DM futures, limiting his loss, if wants to do so, via a stop loss order.
For an investor who has a view on direction and on volatility, the option is the right choice. If you think the DM is likely to fall below the forward rate, and you believe that the market has underestimated the mark’s volatility, then buying a put on German marks is the right strategy.

Who needs American option? Because if offers an additional right- the privilege of exercise on any date up to the expiration date- it gives the buyer greater flexibility and the writer greater risk. American options will therefore tend to be priced slightly higher than European options. Even so, the American option is almost always worth more ‘alive’ than “dead”, meaning that it pays to sell rather than exercise early. The reason for this statement lies in the fact that most option trade at a price higher than the gain that would be made from exercising the option


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