FX Collar
Summary
An FX collar involves buying a cap and selling a floor on the same currencies with the same expiration date. The two options set the upper and lower strike prices.What is an FX collar?
An FX collar involves buying a cap and selling a floor on the same currencies with the same expiration date. The two options set the upper and lower strike prices.
Objective
It allows the holder to manage foreign exchange risk and minimise the cost of the hedging.
How does it work?
A UK firm of exporters will be receiving $10M in a year’s time. They want to enter into a hedging contract to protect the conversion rate and buy a dollar put/sterling call option. However, they do not want to pay a premium so they offset that by selling a dollar call/sterling put option with an equal premium. The dollar put option limits the risk of dollar depreciation, while the dollar call option restricts any benefit from any dollar appreciation.
Advantages
- The holder pays no upfront premium
- Offers protection against unfavourable currency moves
- The holder can benefit from rates between the cap and the floor
Disadvantages
- Limits the holder’s ability to benefit from currency appreciation
- Using a forward contract could offer a better rate
- Termination could incur extra costs depending on the market rate at that time
An example of what an interest rate collar trade could look like.
FX collar graph showing three potential outcomes over time.
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Disclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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