Currency hedging with Options

Hedging with currency options allows you to protect your bottom line against fluctuations in exchange rates.  Even better, you can also benefit if rates start to move in your favour.

Options fall into two basic camps – one where you pay a premium, or fee, up front. One where you don’t pay any premium, but accept a slightly lower rate.

With a premium

You pay a premium, up front, in cash. This lets you buy forward at a fixed rate. It also lets you benefit up to 100% if the exchange rates move in your favour. 

How much you get to benefit generally depends on how much fee you pay. Options where you pay a premium tend to give you a bit more flexibility and freedom.

Without a premium

You don’t pay a fee, so the cost is built into your rate. So as an example, while you might get a rate of 1.20 on a forward contract, you might get a rate of around 1.18 on on a zero premium option. You also get to benefit up to 100% if currency values move in your favour.

Options that don’t carry a premium can be slightly more restrictive than those that do.

A protection option is another form of foreign exchange hedging. Like a forward contract, it lets you set a worst case rate. 

Unlike a forward contract you pay a fee up front called a premium. This premium gives you the right rather than the obligation to buy at this worst case rate.

If the rate moves against you, you just use your worst case rate. However, if exchange rates move in your favour, you can use the improved spot rate.

Advantages

• You get all the benefits of a forward contract

• Guaranteed worst case rate

• You benefit 100% if the rate moves in your favour

Disadvantages

• Upfront premium (cost)

How this works for an importer

Let’s say that the forward contract rate is 1.23. You set your worst case rate at 1.23, and you pay a 2% premium.

Scenario 1 – On expiry, the spot rate is below 1.23 

You buy your euros at 1.23

Scenario 2 – On expiry, the spot rate is above 1.23

You buy your euros at the higher spot rate 

How this works for an exporter 

Let’s say that the forward contract rate is 1.23. You set your worst case rate at 1.23, and you pay a 2% premium.

Scenario 1 – On expiry, the spot rate is above 1.23 

You sell your euros at 1.23

Scenario 2 – On expiry, the spot rate is below 1.23

You sell your euros at the lower spot rate 

A risk reversal is another form of currency hedging. Like a protection option, a risk reversal allows you to set a worst case rate for a fee paid up front (a premium). In addition, it lets you set a best case rate. Because you have this, the premium is less.

If the rate moves against you, you use your worst case rate. If it moves in your favour, you can take advantage of the spot rate. If the spot rate is better than your best case rate, you simply get your best case rate.

Advantages

• Guaranteed worst case rate

• You benefit up to the best case rate if the rate moves in your favour

• Your premium is reduced

Disadvantages

• You cannot benefit beyond your best case rate

• Up front premium

How this works for an importer

Let’s say that the Forward Contract rate is 1.23. You set your worst case rate at 1.23 and your best case rate at 1.35. You pay a premium of 1%.

Scenario 1 – On expiry, the spot rate is below 1.23

You buy your euros at 1.23

Scenario 2 – On expiry, the spot rate is above 1.23 and below 1.35

You buy your euros at the spot rate

Scenario 3 – On expiry the spot rate is above 1.35

You buy your euros at 1.35

How this works for an exporter

Let’s say that the Forward Contract rate is 1.23. You set your worst case rate at 1.23 and your best case rate at 1.11. You pay a premium of 1%.

Scenario 1 – On expiry, the spot rate is above 1.23

You sell your euros at 1.23

Scenario 2 – On expiry, the spot rate is below 1.23 and above 1.11 

You sell your euros at the spot rate

Scenario 3 – On expiry the spot rate is below 1.11

You sell your euros at 1.11

Yet another way of hedging currency risk is a 50% participating forward. You don’t pay a premium, but the worst case rate you agree to will be slightly worse than a forward contract rate. 

However, if the exchange rate moves in your favour, you’ll be able to benefit from 50% of any upside. The reason you don’t get 100% of the upside is that you don’t pay a premium. But you still have 100% protection if rates move against you.

Advantages

• Guaranteed worst case rate

• You benefit 50% in any favourable moves (unlimited)

• Zero premium to pay 

Disadvantages

• Your worst case rate is worse than a forward contract

How this works for an importer

Let’s say that the Forward Contract rate is 1.23. Your worst case rate is set at 1.21. 

Scenario 1 – On expiry, the spot rate is below 1.21

You buy your euros at 1.21

Scenario 2 – On expiry, the spot rate is above 1.21

You buy 50% of your euros at 1.21 and 50% at the higher spot rate. For example, if the spot rate is 1.31, you buy 50% at 1.21 and 50% at 1.31. So the actual rate you achieve is 1.26.

How this works for an exporter

Let’s say that the Forward Contract rate is 1.23. Your worst case rate is set at 1.25. 

Scenario 1 – On expiry, the spot rate is above 1.25

You sell your euros at 1.25

Scenario 2 – On expiry, the spot rate is below 1.25

You sell 50% of your euros at 1.25 and 50% at the lower spot rate. So, if the spot rat is 1.15, you sell 50% at 1.25 and 50% at 1.15. Which means the actual rate you achieve is 1.20.

A convertible forward is a form of hedging currency risk that carries no premium. 

Your worst case rate is slightly worse than the forward contract rate. However, you can benefit 100% if the exchange rate moves in your favour. You also have 100% protection if rates move against you. 

What makes a convertible forward different is this – the best case rate you agree is a ceiling. If the spot rate goes through this ceiling, you revert to a forward contract at your worst case rate. 

Advantages

• Guaranteed worst case rate

• You benefit 100% in any favourable moves up to your best case rate

• Zero premium to pay 

Disadvantages

• Your worst case rate is worse than a forward contract

• If the spot rate goes through your ceiling, you revert to your worst case rate

How it works for importers 

Let’s say that the Forward Contract rate is 1.23. Your worst case rate is set at 1.21 and your best case rate is set at 1.35.

Scenario 1 – On expiry, the spot rate is below 1.21

You buy your euros at 1.21

Scenario 2 – On expiry, the spot rate is above 1.21 and spot has not touched 1.35

You buy your euros at the spot rate

Scenario 3 - On expiry, the spot rate is above 1.21 and has touched 1.35

You buy your euros at 1.21

How it works for an exporter

Let’s say that the Forward Contract rate is 1.23. Your worst case rate is set at 1.25 and your best case rate is set at 1.11.

Scenario 1 – On expiry, the spot rate is above 1.25

You sell your Euro’s at 1.25

Scenario 2 – On expiry the spot rate is below 1.25 and spot has not touched 1.11

You sell your euros at the spot rate.

Scenario 3 - On expiry, the spot rate is below 1.25 and has touched 1.11

You sell your euros at 1.25

Important

For this kind of foreign currency hedge, you can set a time period in which the breach has to happen for the contract to revert to the worst case rate. For example if you set the time period for one month, the rate must breach your best case rate within that month for you to revert to your worst case rate. Outside of that month any breach does not count. You can set that time period to any time you like.