A Fresh Approach to Currency Hedging (P.3)
Over the last two issues we have covered both a strategy that involves zero hedging (with no protection) and one with complete protection (but no opportunity). We have seen the inherent problems with both. Today we are looking at simple Options, that aim to tackle the problems of each strategy by giving 100% protection while enabling 100% opportunity simultaneously. But before you jump on the phone to call your dealer about this little silver bullet, let’s take a closer look…
For today’s comparison just remember that Forwards give you 100% protection with Zero Opportunity.
Now, what is an Option?
An Option is a derivative or financial instrument which enables the buyer to lock in a worst-case exchange rate, for a certain period of time and for a predetermined amount. Because they are a derivative, there is a lot to consider when adding Options strategies to your currency hedge.
Firstly, there are many types of Option strategies designed for many different types of importers, more than we will cover in today’s blog. The motivation to look at options comes from both the lack of protection from Spot-Only Payments and the lack of upside opportunity from Forward Contracts. In short, Options are usually designed in order to provide some upside opportunity with some level of protection.
Do be careful!
Many Option strategies are positioned by the FX provider as ‘zero cost’ which is not the actual case. There is always a cost involved, so always ask “where’s the catch?” In most cases ‘zero cost’ just means zero upfront cost, which can be a real benefit to an importer, however it’s always prudent to understand all of the features of such a strategy before you commit.
Where do I start?
The most basic Option is known as a ‘Vanilla’ Option, which denotes it’s plain structure. In essence, this is simply an insurance policy against the event that the market moves down. As with insurance, we have to pay a premium in order to take the contract. The longer the timeframe of the Option, the more expensive it will be to take (there are other considerations in pricing an Option, however time will be most important for our purposes), just as with any other insurance policy.
If the market moves down significantly, your Option premium value will increase. Therefore, even though you will be paying your invoices at a worse rate, the profits that you make on your Vanilla Option’s premium will theoretically offset these losses in spot payments.
If the exchange rate moves up significantly, your Option should become worthless. However, you can only lose the amount that you paid for your Option the premium. This means that now you can make your invoice payments at a much better rate.
Here we can see that, once we have absorbed the cost of the Option (premium = shaded area denoted by ‘Cost of Protection’), we can take full advantage of every cent that the exchange rate moves up. The cost of absorbing this Option is equivalent to giving up more than 5c in this example (it can be more or less), if we equate the premium back to cents in the dollar of the invoiced amount.
Basically on the upside we are paying the spot rate for all invoices during the term of the Option Therefore, if the market moves to 113 cents, we pay invoices at a far better rate. On the downside, if the market moves to 75c, our Vanilla Option increases in value to absorb this. Because we had to pay upfront for this Option strategy, effectively our protection level is at 99c (though if we factor in the ‘Cost of Protection’ our effective protection level is at 94c).
If the market moves to 75c we are effectively protected for every cent movement from 94c onwards. Therefore we are basically about 5c worse off which is simply the cost of the Option premium.
VANILLA OPTION STRATEGY = 100% Protection with 100% Opportunity*
* plus the cost of the Option premium.
Note that there can be problems with settling an Options strategy. This is not within the scope of today’s blog but worth asking your FX provider about before you enter into a contract. Also, now let us expand on this strategy a little. The idea of 100% protection with 100% upside opportunity is extremely attractive. Always remember that nothing comes for free. In this case you take into account that there is a considerable cost called premium involved.
Finally note that this cost is upfront, meaning that we need to pay for this on day one, not when the invoices are paid. Upfront payments for a shipment that won’t arrive for 60 days can be a real hurdle for many businesses, so it’s prudent to look at your cash-flow arrangements before considering an Option strategy. You may be tempted to look at ‘zero cost’ options for this reason, but always ask what the catch is?
In the next instalment we will take a look at an example of a ‘zero cost’ option, and consider the pros and cons attached with a strategy of this nature.
By Marcus Addison
Marcus Addison has over 15 years of experience in currency markets. He has worked in eTrading for the largest FX provider in the world, Deutsche Bank and has traded both as a Hedge Fund Manager and as a professional Proprietary Trader for the largest electronic derivatives group in Europe. He now focuses on using his trading and foreign exchange experience to help both importers and exporters wade through the currency maze with Addison Capital.
General Disclaimer : All ideas, opinions, recommendations and/or forecasts, expressed or implied herein, are for informational and educational purposes only and should not be construed as financial product advice or an inducement or instruction to invest, trade, and/or speculate in the markets. All trading and investing activities are subject to the usual market fluctuations that may result in gains and losses. Any action or refraining from action; investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk and consequence, financial or otherwise. Please seek legal and/or financial advice before taking or refraining from such action. Past or historical results may have no bearing of current or future trading or system results.