Foreign currency options: How to use advanced hedging strategies

The future by definition is uncertain. And I can’t think of anything more uncertain than foreign exchange rates. The supply and demand for currencies are influenced by almost an unlimited amount of factors. Everything from the performance of an economy through to who holds political power can affect the prices you pay.

If you are looking at making a large international transaction, there’s a good chance that you’re exposed to exchange rate risk. There are a number of hedging strategies that can be used to minimise this risk, with one of these instruments being foreign currency options.

In this post, we’ll take a look at how a foreign currency option works, and how they can be used to minimise the exchange rate risk of financial transactions occurring in the future.

What is a foreign currency option?

A foreign currency option gives you the right, but not the obligation to purchase a particular currency at a predetermined exchange rate. They are one of the most common and helpful ways of protecting a financial transaction from adverse exchange rate movements and are used by individuals, small businesses and large corporations alike.

Foreign exchange options can be an extremely versatile tool. At its core, a currency option can help a business protect the value of an international transaction, such as purchasing property or acquiring goods from a supplier, by limiting the risk associated with a potential adverse movement in rates. In these instances, the exchange rate risk can not only affect the viability of the transaction but even the business itself.

But more than that, a foreign currency option can be combined with other tools offered by money transfer services such as a spot contract or currency forward contract. By combining the use of a currency option with other foreign exchange products, hedging strategies can be devised to protect a transaction, or even profit from it, no matter what the future holds.

How can currency options be used?

Currency options are best thought of as an agreement between two parties where an exchange rate is agreed for a future date. The date can be set anywhere from one week to two years from the period when the contract is agreed. The two parties will typically consist of you and a financial institution, such as a bank or specialised money transfer service.

When foreign currency options are used alone, the buyer of an option usually pays a small premium to the seller of the option. The cost of the premium will vary depending on a few factors, such as the number of currency option contracts purchased, their value, and who the seller is. If an option is purchased alongside another technical instrument, the option can be packaged into the overall pricing of the hedging strategy.

A foreign currency option comes in two forms:

Call option. A call option provides you with the right, but not an obligation, to purchase a currency at a specified price. For example, let’s assume that you purchased a GBP/USD call option at the exchange rate of 1.3000, with a maturity date in 90 days time. If, after 90 days, the GBP/USD exchange rate had depreciated to 1.2000, you could proceed to exercise your right to purchase US Dollars in exchange for British Pounds at the preferred rate of 1.3000.

Put option. A put option gives you the right but not obligation to sell currency at the specified price. If we take our previous example and look at the inverse, consider that you purchased a GBP/USD put option at the exchange rate of 1.3000 with a 90-day maturity. If, after 90 days, the GBP/USD had appreciated to 1.4000, it would be best to exercise your right to sell US Dollars in exchange for British Pounds at the preferred rate of 1.3000.

In the money or out of the money

Just because you’ve purchased an option to buy or sell currency, doesn’t always mean that it will be right to proceed with exercising it once it reaches maturity. This flexibility, the choice to proceed with exercising an option or not, is one of the reasons why they are so popular. It effectively acts as a form of insurance, so you can proceed with the most favourable solution at the time.

At the maturity of an option, you will arrive into one of two scenarios:

In the money. A currency option which presents itself as being favourable to execute is referred to as being “in the money”. This means that the exchange rate of the option is better than the currently available spot rate. In this case, it would be best to execute the option and purchase your currency at the pre-agreed rate. The benefit to you is that you have saved money by not having to purchase your currency at the higher spot rate.

Out of the money. A currency option which presents itself as being unfavourable to execute is referred to as being “out of the money”. This means that the exchange rate of the option is worse than the currently available spot rate. In this case, it would be best to allow your option to expire, and instead, buy your required currency at the spot rate.

Common hedging strategies using currency options

While it is certainly possible to use a foreign currency option in isolation, when combined with other foreign exchange instruments, such as a forward contract, they become even more powerful. Using these tools together can enable a multi-layered hedging strategy, which allows you to benefit no matter which way an exchange rate moves.

The are four types of hedging strategies which commonly use options:

Vanilla option. Gives you the right, but not the obligation, to buy or sell currency at a specific exchange rate on a specific future date. Its name, vanilla, implies that it is the most basic form of option there is. A small premium is paid for acquiring the option, then at its maturity date, you can decide whether or not you’d like to proceed with your purchase at the agreed rate.

A vanilla option allows you to benefit from any favourable movements in the market while acting as worse case rate to protect you from unfavourable movements. By maturity, if the exchange rate has moved in your favour, you can simply allow the option to expire and instead purchase currency at the spot rate.

Collar option. Enables you to set a worst-case rate, while also allowing favourable moves up to a specified best case rate. This structure sets a window around the exchange rate, so you know that at the very least, the rate you will eventually purchase currency at will fall between the worst and best case rate. It is effectively a hedge in both directions, so you can’t lose too much, and you can’t gain too much either.

At the maturity of the option, if the spot rate is in between the worst and best case rates, you can proceed with purchasing your required currency at the spot rate. If the spot rate is less than the worst case rate, you will be able to purchase at the worst case rate. However, if the spot rate is higher than the best case rate, you are required to purchase at the best case rate. Collar options are generally structured in a way that no premium is paid for their use.

Participating forward. Provides a protected worst case rate, while still allowing favourable moves on a predetermined portion of the amount hedged. For example, a 50% participating forward means that the whole amount of the currency to be purchased is protected at the worst case rate, but only 50% of the amount can benefit from a favourable movement in the exchange rate.

At the maturity of the forward, if the spot rate is better than the worst case rate then you are only obligated to purchase the predetermined proportion of the hedged amount at the worst case rate, while the rest can be purchased at the improved spot rate. Participating forwards are generally structured in a way that no premium is paid for their use.

Forward extra. Locks in a worst case rate while allowing for favourable moves up to a predetermined trigger rate, but no more. If the trigger rate is met or exceeded at any time during the life of the forward, you are required to purchase your currency at the worst case rate. When selecting a trigger rate, the aim is to make it high enough so that the spot rate may approach but not reach it.

If the spot rate on expiry is in between the worst case and trigger rate, you can purchase currency at the improved spot rate. If the spot rate at expiry is less than the worst case rate, you can purchase currency at the worst case rate. Forward extras are generally structured in a way that no premium is paid for their use.

Practical examples of foreign currency options in use

Let me give you two examples of how a foreign currency option can be used as part of a hedging strategy in a real-world situation.

Example 1: Option on its own

Let’s say that you run a company based in the United Kingdom, and have just purchased a piece of equipment from a supplier in the United States. The cost of the equipment is US$ 100,000 and payment is due in six months time. The current GBP/USD spot rate is 1.3000, and if you wanted to, you could pay the supplier today for a total cost of £76,923.

But for commercial reasons, you would rather hold onto your money and instead hedge your intention to purchase US Dollars with a vanilla option. A forward rate is typically slightly lower than the spot rate, and an option rate is slightly lower again. You decide to purchase an option with the worst case rate of GBP/USD 1.2900, which matures in six months. The premium charged for the option is 2.5% or US$ 2,500.

So, now let’s consider the first of two possible scenarios. By the time the option matures, the market moves against you and the GBP/USD weakens by 10% to 1.1610. If you had not purchased an option, you would now need to pay £86,132 to acquire US Dollars. Instead, you were sensible enough to hedge your position. So, by now executing your option at the rate of 1.2900, you are entitled to purchase the full US$ 100,000 at a total cost of £79,442, including the cost of the option’s premium.

On the other hand, what happens if the market moves in your favour and the GBP/USD strengthens by 10% to 1.4190? In this instance, you could simply let your option lapse, and instead, buy US$ 100,000 at the spot rate for a total cost of £72,395, including the premium of the forgone option. Overall, this strategy has offered protection from downside risk, while allowing you to benefit from the strengthing Pound.

Example 2: Option combined with a forward contract

Once again, let’s put your feet in the shoes of a company located in the United Kingdom, who has just purchased a piece of equipment from a supplier from the United States. The price of the equipment is unchanged at US$ 100,000, with payment due in six months time. The current spot rate is 1.3000, and to pay the supplier today would cost you £76,923.

This time around, you decide to use a more complex hedging strategy; a participating forward. The forward rate for a six month period is 1.2950, but you are prepared to accept a worst case rate of 1.2800. As a result, you buy a participating forward at a rate of 1.2800 with a participation proportion of 50%. The forward matures in six months, however, no premium is payable; as the costs are built into the product.

In our first scenario, by the time the forward matures, the market moves unfavourably and the GBP/USD rate weakens by 10% to 1.1520. If you had not purchased a participating forward, you would now need to pay the current spot rate, leading to a total cost of £86,805. Instead, because the full amount of your purchase is protected by the hedge, you can acquire your US Dollars at 1.2800 for a total cost of £78,125.

If instead, the Pound had strengthened over this time, things would look a little different. Because you elected to proceed with a participation proportion of 50%, only half of your currency purchase would benefit from favourable movements. Had the GBP/USD appreciated by 10% to 1.4080, half of your US Dollars would be purchased at 1.2800 and the other half at the improved spot rate of 1.4080. This would lead to a new effective rate of 1.3409 and a total cost of £74,573.

Benefits of using foreign currency options

If your business often deals in international markets, there is a good chance that you’re exposed to exchange rate risk. These risks can have a significant effect on your budget, profit margins, and ultimately the viability of your business. And while it is possible that private individuals may find the need for currency options, they are more commonly used by businesses and corporations.

Here are some of the benefits resulting from the use of foreign currency options and other hedging strategies:

• Protects the profit margins of a transaction
• Manages the impact that foreign exchange volatility has on your business
• Enables you to accurately forecast financial performance
• Allows you to maintain consistent pricing of goods and service despite fluctuating rates

Where to buy a foreign currency option

Below is a list of money transfer services which offer foreign currency options and advice on foreign exchange hedging:

Conclusion

A foreign currency option is a versatile tool for managing exchange rate risk. Used on its own or in conjunction with other instruments, it can provide you with peace of mind when the future value of a currency is unclear. There is a range of money transfer services that can facilitate and provide advice on a range of hedging strategies, which is particularly useful for businesses conducting transactions internationally.