FX — choosing different hedging strategies and when to opt for an option

How does an FX option work?

An FX option is a contract that confers on the holder the right, but not the obligation, to exchange an amount of one currency for another at a pre-agreed rate (strike rate) on or before a pre-agreed date. It provides protection against an adverse movement in the chosen currency at the agreed-upon strike rate.

When is an FX option used?

Using options as part of a hedging strategy are sometimes discounted as the payment of a premium can be unattractive. However, there are a few reasons why using options should be considered as part of a currency hedging strategy.

• Flexibility: A purchased FX option gives the buyer the right (but not an obligation) to exchange at the strike rate. This offers the buyer the flexibility to unwind prior to maturity at no cost, and to recuperate any remaining value in the option. Options are most appropriate when cash flows (both quantum and timing) are uncertain (e.g., from profits or rental income). In some circumstances, those cash flows do not materialize at all. In this event, the option purchased can be unwound with any residual value returned to the buyer.
• Establishing a worst-case scenario: An FX option allows the buyer to establish a worst-case scenario. After the premium is paid, the worst-case rate at which the buyer of an option would convert the currency is the strike rate. For example, let’s consider the scenario where one bought an option with the following details:
  • Put EUR 50 million, call USD, at a strike of EUR-USD 1.19 (at the money spot) for an expiry of two years with a cash premium cost of USD 2.5 million
  • The buyer of the option will be able to calculate the worst-case effective rate at maturity by converting 50 million of EUR with the rate 1.19 (the option being exercised) and deducting the cost (i.e., the premium paid); the USD inflows after exercising the option and paying the premium would be EUR 50 million * 1.19 – USD 2.5 million = USD 57 million which gives a worst-case rate of 1.14 (=USD 57 million/EUR 50 million)

• Strong belief in the upside: The ability to participate in a favorable currency movement is one of the most appealing aspects of an FX option. As opposed to an FX forward, an FX option allows the buyer to let the option expire if it is out-of-money. An option will expire out-of-money if the spot conversion rate is better than the agreed option strike rate, and the buyer will not be obliged to settle anything. The buyer can then convert the currency at the more favorable spot rate in the market. Of course, the premium cost is now “sunk”, but if the favorable movement is material enough, then that should be offset by the gain made on the FX.
• No credit required: Once the option premium is paid, an option will never be a liability to the buyer. The worst case is for the option to expire worthless, and the premium cost is sunk. The hedge counterparty, therefore, has no credit exposure. The process of setup is simpler and the time from decision to execution much shorter. This can be useful when the need to hedge arises before an FX credit line is set up. Since an option can only be an asset to its buyer, the buyer should have less concern of the mark-to-market movements. The option would not negatively impact the buyer’s overall balance sheet.

Buying an FX option means paying a premium and that upfront cost can be unappetizing when compared with other hedge strategies like an FX forward. However, there are many cases where an FX option will be the most suitable hedging strategy. Chatham can partner with you to determine if an FX option fits your goals and risk appetite, and can provide the necessary analysis for you to select the appropriate hedging strategy.