Hedging your risk with currency options

A protection option is effectively an insurance policy. Like a forward contract, it lets you set a worst case rate and so protects you if the exchange rate moves against you.

Unlike a forward contract you pay an upfront fee called a premium. When you take out a protection option, you reserve the right to buy currency at a fixed rate at a point in the future. When that time comes, you have 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)

You are buying an American home in 6 months’ time for $500,000.

Let’s say that the forward contract rate is 1.5570. You feel that the rate could get better (i.e. higher) but also don’t want to risk buying your dollars at a rate worse (i.e. lower) than 1.60.  You choose a protection option, set your worst case rate at 1.60, and you pay a 1.5% premium.

Scenario 1 – When the contract ends, the spot rate is above 1.60, at 1.62

You buy your dollars at the higher spot rate of 1.62, and pay £ 308,642 for the property.

Scenario 2 – When the contract ends, the spot rate is below 1.60, at 1.52

You buy your dollars at 1.60 and pay £ 312,500 for the property.

You are selling your American home in six months’ time for $500,000

Let’s say that the forward contract rate is 1.5570. You feel that the rate could get better (i.e. lower), but also don’t want to risk converting your dollars to pounds at a rate worse (i.e. higher) than 1.60.  You choose a protection option, set your worst case rate at 1.60, and you pay a 1.5% premium.

Scenario 1 – When the contract ends, the spot rate is below 1.60, at 1.52

You sell your dollars at 1.52, and you get £328,947 for the property.

Scenario 2 – When the contract ends, the spot rate is above 1.60. at 1.62

You sell your dollars at 1.60, and you get £312,500 for the property.

If you want to protect yourself against currency rates shifting unfavourably… but don’t want to pay a large premium, then a risk reversal could be just the thing for you.

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 reduced fee paid up front (a premium). In addition, it lets you set a best case rate. Because you have this, the premium is reduced, sometimes to zero. 

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

You are buying a house in France for €350,000 in 3 months time.

Let’s say that the Forward Contract rate is 1.2350. You feel the rate might get even better (i.e. higher) and also you know you don’t want to exchange at a rate lower than 1.20. A protection option at a rate of 1.20 would cost you 3.5%. We recommend a risk reversal to minimise your upfront cost and allow you to protect yourself.  You set your worst case rate at 1.20 and your best case rate at 1.26. You pay no premium in this case.

Scenario 1 – When the contract ends, the spot rate is below 1.20

You buy your euros at 1.20 and pay £291,667 for the property (your worst case).

Scenario 2 – When the contract ends, the spot rate is above 1.20 and below 1.26, at 1.25

You buy your euros at the higher spot rate of 1.25 and pay £280,000 for the property.

Scenario 3 – When the contract ends, the spot rate is above 1.26, at 1.283

You buy your euros at 1.26 and pay £277,778 for the property.

Risk reversals are flexible. The band of rates can be altered to suit you. You can choose zero premium or paid premium.

You are selling a house in France for €350,000 in 3 months time. 

Let’s say that the Forward Contract rate is 1.2350. You feel the rate might get even better (i.e. lower) and also you know you don’t want to exchange at a rate higher than 1.26. You set your worst case rate at 1.26 and your best case rate at 1.20. You pay no premium in this case.

Scenario 1 – When the contract ends, the spot rate is above 1.26, at 1.32

You sell your euros at 1.26 and get £277,778 for the property (your worst case).

Scenario 2 – When the contract ends, the spot rate is below 1.26 and above 1.20, at 1.25 

You sell your euros at the lower spot rate of 1.25 and get £280,000 for the property.

Scenario 3 – When the contract ends, the spot rate is below 1.20, at 1.18

You sell your euros at 1.20 and get £291,667 for the property.

Risk reversals are flexible. The band of rates can be altered to suit you. You can choose zero premium or paid premium.

One 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 from favourable currency moves on 50% of your money

• Zero premium to pay 

Disadvantages

• Your worst case rate is slightly worse than a forward contract

You are buying a house in Italy for €1 million in six months’ time.

Let’s say that the Forward Contract rate is 1.23. You decide to use a 50% participating forward because you can fix a worst case rate and you can also participate if the exchange rate moves in your favour (i.e. higher).  You set your worst case rate at 1.20.

Scenario 1 – When the contract ends, the spot rate is below 1.20, at 1.176

You buy all your euros at 1.20 and pay £833,333 for the property.

Scenario 2 – When the contract ends, the spot rate is above 1.20, at 1.40

You buy 50% of your euros at 1.20 and 50% at the higher spot rate of 1.40. So the average exchange rate you achieve is 1.30.  You pay a total of £773,810 for the property.

You are selling a house in Italy for €1 million in six months’ time.

Let’s say that the Forward Contract rate is 1.23. You decide to use a 50% participating forward because you can fix a worst case rate and you can also participate if the exchange rate moves in your favour (i.e. lower).  You set your worst case rate at 1.25.

Scenario 1 – When the contract ends, the spot rate is above 1.25, at 1.33

You sell all your euros at 1.25, and you get £800,000 for the property.

Scenario 2 – When the contract ends, the spot rate is below 1.25, at 1.20

You sell 50% of your euros at 1.25 and 50% at the lower spot rate of 1.20. Which means the average rate you achieve is 1.225.  You get a total of £816,667 for the property.