Hedging Exchange Rate | Currency risk using Options
Options are radically different. They give the holder the right, but not the obligation, to buy or sell a given amount of currency at a fixed exchange rate (the exercise price) in the future (if you remember, forward contracts were binding). The right to sell a currency at a set rate is a put option (think: you ‘put’ something up for sale); the right to buy the currency at a set rate is a call option.
Suppose a UK exporter is expecting to be paid US$1m for a piece of machinery to be delivered in 90 days. If the £ strengthens against the US$ the UK firm will lose money, as it will receive fewer £ for the US$1m. However, if the £ weakens against the US$, then the UK company will gain additional money. Say that the current rate is US$/£1.40 and that the exporter will get particularly concerned if the rate moved beyond US$/£1.50. The company can buy £ call options at an exercise price of US$/£ = 1.50, giving it the right to buy £ at US$1.50/£. If the dollar weakens beyond US$/£1.50, the company can exercise the option thereby guaranteeing at least £666,667. If the US$ stays stronger – or even strengthens to, say, US$/£1.20, the company can let the option lapse (ignore it) and convert at 1.20, to give £833,333.
This seems too good to be true as the exporter is insulated from large losses but can still make gains. But there’s nothing for nothing in the world of finance and to buy the options the exporter has to pay an up-front, non-returnable premium.
Options can be regarded just like an insurance policy on your house. If your house doesn’t burn down you don’t call on the insurance, but neither do you get the premium back. If there is a disaster the insurance should prevent massive losses. Options are also useful if you are not sure about a cash flow. For example, say you are bidding for a contract with a foreign customer. You don’t know if you will win or not, so don’t know if you will have foreign earnings, but want to make sure that your bid price will not be eroded by currency movements. In those circumstances, an option can be taken out and used if necessary or ignored if you do not win the contract or currency movements are favourable.