Option Contracts Are the Weapon of Choice When Hedging Forex Risk

Dec 142011

Guest Article By Forex Traders

One aspect of this era of globalization is that more consumers and investors have become informed when it comes to our foreign currency markets and how modest fluctuations can impact investment returns and general prices for common goods in our retail space. One aspect that is not well understood, however, is that corporations are also exposed to forex risk, and their respective treasury departments are responsible for mitigating any material currency risks due to exchange rate changes over time.

This area of risk management goes by the name of currency hedging, the process for minimizing the financial impacts of fluctuating exchange rates. Those familiar with currency trading know that the forex market is our largest and most liquid financial market in the world, transacting over $4 trillion a day in total turnover. If we ignore speculation, roughly 80% of that figure, the remainder relates to global commerce, capital transfers, and hedging foreign exchange commitments in the future.

The hedging process starts with a detailed cash flow projection that “nets” specific exposures on a foreign currency basis. These “nets” may be due to revenues from foreign sources, the operations of foreign subsidiaries, or purchases or investments denominated in a currency other than the U.S. Dollar. The treasurer’s staff will attempt to match assets and liabilities by currency on the balance sheet, but the remaining “exceptions” become the focus of increased analysis.

At this stage, the risk exposures can be detailed by amount and by time period. By assuming hypothetical exchange rate changes, a valuation of the risk can be estimated. Individual investors can go through a similar process to ascertain what their forex risks ecmight be in the future and plan accordingly.

In the not too distant past, treasurers would buy or sell forex forwards to “fix” exchange risk based on today’s values, committing the necessary capital with their banker to cover the future commitment. In some cases, the bank might “write” a customized option agreement for a fee that locked in a rate for a fee, very similar to buying insurance to protect against a known risk of doing business. This process did away with the capital commitment requirement, but allowed for participation on the upside if currencies moved favorably over the period. If the risk/reward dynamics exceeded the option premium cost, then the option would be purchased and the risk, thereby hedged.

An example will help illustrate these concepts. First assume that you have contracted to pay a company in Germany 10,000 Euros in six months. You are advised to hedge your Euro exposure risk by buying a “EUR/USD” call option for $13,500 at the estimated future date at today’s exchange rate. If the Euro weakens, then you let the option expire and buy Euros at a more favorable exchange rate than now. If the Euro strengthens to $1.50, then your option appreciates. The profit on the option, less the premium paid, offsets the higher value of $15,000 for your obligation. Your risk is hedged, but you retained the ability to benefit from a weakening Euro.

Analysts usually plot this scenario on a risk graph. Risk Graphs are simple diagrams made up of 2 axes and a line representing option price at various values of the underlying security or currency. The horizontal X-Axis represents the value of the underlyer, and the vertical Y-Axis represents the option profit or loss, as depicted below:

Forex Option: Profit & Loss Diagram "EUR/USD"

This example is very simple, but the hedging process can get complex very quickly. If you expect the Dollar to strengthen, seek professional assistance if you wish to hedge.

Guest Article – The above article is by Forex Traders and does not necessarily reflect the opinions of the author of FullyInformed.com