Previous pieces in our five-part FX options series have discussed how forex options work and how both simple and complex option products can be used to hedge FX risk. This article explores how businesses can combine options and other instruments for more effective FX risk management.
It assumes readers are familiar with the basic operation of options and the terminology used to describe them. If not, please review the Basic FX Options piece. Key to understanding the forex options strategies described below for FX risk management is the underlying fundamental principle of put-call parity.
This defines a reliable relationship between options and forward contracts , which can help businesses when choosing appropriate hedging strategies to suit their circumstances. To demonstrate this principle, imagine an Australian farmer is selling lamb three months forward to a British meat importer. Similarly, if the exchange rate has moved to 0. Put-call parity means that a purchased call option is equivalent to a written put option for the same currency pair, expiration date and strike price: Whether to purchase or write an option depends on the view of exchange rate movements.
A purchased option has limited risk and potentially unlimited reward, while a written option has limited reward and potentially unlimited risk.
It is easy to assume that because of the potentially large losses and limited rewards from writing options, they have no place in a hedging strategy. Call and put options can be combined to create hedges to suit particular needs. Typically, these combinations work for companies that want to manage cash balances in multiple currencies so as to gain from beneficial FX movements while minimizing notional losses from adverse movements.
Following are some commonly used combinations. A long straddle combines a purchased call and purchased put option in the same currency, with the same strike price and expiration date. If it appreciates, the put option will be in-the-money and therefore the company will sell currency.
Effectively, this combination enables the company to switch between two currencies depending on the direction of the exchange rate. It is useful for a company that wishes to manage its FX exposures actively and has no pressing cashflow needs.
For example, consider an Australian exporter that is selling regularly to the U. A short straddle combines a written call and written put option, providing a similar currency switch while enabling the business to profit from the option premiums. However, it is a riskier strategy, since a large movement in the exchange rate could result in large losses.
A strangle is similar to a straddle except that the strike price of the two options is different — usually, the call option has a higher strike price than the put option. A long strangle can be a cheaper cashflow hedge than a long straddle, but it allows the exchange rate to fluctuate more and therefore does not fully protect against FX losses on the currency switch.
A long strap is a combination of two purchased call options with a purchased put option, all with the same strike price and expiration. It is effectively a straddle with double the upside potential. A long strip is a combination of two purchased put options with a purchased call option, again all with the same strike price and expiration. A strap is a bullish bet on a big currency move: Both can be constructed with written options, gaining the company income from premiums, but this is a riskier strategy and the potential losses could be very large.
A call option bull spread involves buying a call option while simultaneously writing a call option in the same currency pair for the same expiration at a higher strike price. It is essentially a bet that the currency will appreciate modestly. There is no downside risk, since if the currency does not appreciate the option will expire. The business benefits from the premium on the written option; but if the currency appreciates a lot, there are potentially large losses.
This is a bet that the currency will depreciate modestly. It carries the same benefits and risks as a bull spread. Bull and bear spreads can also be created using put options. Synthetic forwards can be helpful for smoothing cashflow. In an outright forward, the eventual settlement is at the forward price on expiry. Conversely, in a synthetic forward, there is likely to be an initial margin and the net position will be cash settled daily variation margin ; if the option is properly priced, the eventual settlement should be entirely covered by the margin posted.
Companies working in multiple currencies sometimes adopt a mixed FX risk management strategy involving both forward contracts and options.
One large European bank evaluated the benefits of using 50 percent forward contracts, 50 percent forex options for major developed country currencies, and a higher proportion of forex options for developing country currencies.
It concluded that there was a cost benefit from using a proportion of forward contracts for major currencies over an entirely option-based strategy. Businesses can combine forex options to create FX risk management strategies tailored to their needs. Option combinations can be particularly useful for businesses with multiple currency exposures, since it can help them to take advantage of exchange rate movements between the currencies in which they deal.
Forex options can also be combined with forward contracts to create a cost-effective hedging strategy for multiple currency exposures. However, combinations can be risky: Tailored hedging with forex options is not suitable for all businesses. With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications.
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