Foreign Currency Options Hedge Using Call & Put Options

Currency options are more flexible as it provides perfect hedge without binding organization, as currency futures (future contract) and forward contract binds the organization.

Currency option provides the right without binding the holder to exercise at specific price (exercise price) until expiry date. After expiry date, option is lapse it means cannot be exercised afterwards. However, option may be exercised before the expiry date.

Cost of option is the amount of premium paid at the time of entering into option. Premium is not refundable in any case. Cost of premium can be substantial such as 10% of the amount of foreign currency to be hedged.

US option gives the right to the holder to exercise it anywhere from issue date to expiry date. UK option gives the right to the holder to exercise only at expiry date. Therefore, in practice, US option is more popular than UK option; therefore, we will assume US option in the following discussion.

Holder of the option will exercise if it results in gain (option is in the money) and will not exercise if it results in loss (option is out of the money).

If organization is required to pay foreign supplier, then it should enter into call (right to buy foreign currency in future) option. If organization is expecting to receive money from foreign customer, then it should enter into put (right to sell foreign currency in future) option.

Holder of the call option will exercise if exercise price is lower than foreign exchange rate at exercise date. Organization will benefit by purchasing at lower rate (exercise price) than it would buy at foreign exchange rate in the market. If exercise price is higher than foreign exchange rate, then organization is free to allow it to lapse.

Holder of the put option will exercise if exercise price is higher than foreign exchange rate at exercise date. Organization will benefit by selling at higher rate (exercise price) than it would sell at foreign exchange rate in the market. If exercise price is lower than foreign exchange rate, then organization is free to allow it to lapse.

Option can be purchased from bank if over the counter (OTC) or tailor made option is desired.

Option can also be purchased from option exchange if standard option is available. Standard option is only available in limited foreign currencies. Standard options can be sold in the option exchange just as ordinary shares can be sold in stock exchange.

Organization, that sells (call or put) option is known as option writer. Option writer exposes itself to foreign exchange risk in return for premium, which represents profit to the option writer.

 

Benefits

Option is useful when outcome of the future transaction is not known.

When preparing pricing lists for goods or services.

In case, managers are risk averse. Managers may want to protect organization against both foreign exchange risk and losses due to application of wrong hedging techniques.

 

Limitations

Cost of premium can be substantial.

Payment is required in advanced.

Tailor made option cannot be sold in option exchange.

Standard options are not available in every foreign currency.

Forward Contract to Hedge Foreign Currency or Exchange Risk

Forward contract is Hedging instrument offered by financial institutions such as banks.

Forward contract involves agreement of buying or selling of foreign currency at pre-determined rate at settlement date. Rate is determined at the time of entering into contract.

Forward contract usually requires no or little payment in advance for entering into contract.

Forward contract requires settlement on net basis for any gain or loss realised on foreign exchange.

In case of expected receipt (inflow) in foreign currency, business should enter into forward contract to sell foreign currency because selling involves outflow of foreign currency.

In case of payment (outflow) required in foreign currency, business should enter into forward contract to buy foreign currency because buying involves inflow of foreign currency.

Risk associated with inflow will be cancelled by risk associated with outflow of foreign currency, which consistent with the primary rule of hedging.

There are four scenarios possible for hedging:

• Expected receipt in foreign currency with actual increase in foreign exchange rate.
• Expected receipt in foreign currency with actual decrease in foreign exchange rate.
• Payment required in foreign currency with actual increase in foreign exchange rate.
• Payment required in foreign currency with actual decrease in foreign exchange rate.

 

Receipt

In case of expected receipt, loss due to decrease in foreign exchange rate will be offset by gain on forward contract and gain due to increase in foreign exchange rate will be offset by loss on forward contract.

 

Scenario 1 (Gain on Forward Contract)

Forward contract will result in gain if forward rate agreed is higher than market rate at settlement date. Because organization will sell foreign currency at rate higher than the rate for which foreign currency could be sold in the market. Bank will pay the difference for gain (forward rate – market rate) incurred by the organization.

Organization can then sell the receipts in foreign currency at market rate (spot rate at settlement date) in market. This way organization has fixed exchange rate at forward contract rate (market rate + gain on forward contract) at agreement date.

 

Scenario 2 (Loss on Forward Contract)

Forward contract will result in loss if forward rate agreed is lower than market rate at settlement date. Because organization will sell foreign currency at rate lower than the rate for which foreign currency could be sold in the market. Organization will pay difference to the bank for loss (forward rate – market rate) incurred by the organization.

Organization can then sell the receipts in foreign currency at market rate (spot rate at settlement date) in market. This way organization has fixed exchange rate at forward contract rate (market rate – loss on forward contract) at agreement date.

 

Payment

In case of payment required, loss incurred due to increase in foreign exchange rate will be offset by gain on forward contract and gain due to decrease in foreign exchange rate will be offset by loss on forward contract.

 

Scenario 3 (Loss on Forward Contract)

Forward contract will result in loss, if forward rate agreed is higher than market rate at settlement date. Because organization will buy foreign currency at rate higher than the rate for which foreign currency could be bought in the market. Organization will pay the difference to the bank for loss (forward rate – market rate) incurred by the organization.

Organization can then buy foreign currency at market rate (spot rate at settlement date) from market to pay suppliers. This way organization has fixed exchange rate at forward contract rate (market rate + loss on forward contract) at agreement date.

 

Scenario 4 (Gain on Forward Contract)

Forward contract will result in gain, if forward rate agreed is lower than market rate at settlement date. Because organization will buy foreign currency at rate lower than the rate for which foreign currency could be bought in the market. Bank will pay the difference for gain (forward rate – market rate) incurred by the organization.

Organization can then buy foreign currency at market rate (spot rate at settlement date) from market to pay suppliers. This way organization has fixed exchange rate at forward contract rate (market rate – gain on forward contract) at agreement date.