Introduction

In foreign exchange markets, managing currency risk is crucial for businesses and investors engaged in international trade and investment. One effective approach to mitigate currency risk is through the use of options. Chapter 7 explores the rationale behind multi-currency hedging using options and discusses various option strategies to hedge foreign exchange exposure. Options provide flexibility and allow market participants to protect themselves from adverse currency movements while maintaining the opportunity to benefit from favorable ones. Understanding the concepts presented in this chapter will empower businesses and investors to make informed decisions when implementing multi-currency hedging strategies.

Rationale for Multi-Currency Hedging

Multi-currency hedging using options serves as a risk management tool to protect against unfavorable currency fluctuations while capitalizing on advantageous movements. The key rationale for using options lies in their asymmetric nature. Options provide the right but not the obligation to buy (call option) or sell (put option) a specified currency at a predetermined exchange rate (strike price) on or before a specified date (expiration date). This asymmetry allows hedgers to limit their downside risk while retaining the potential for upside gains. By utilizing options, businesses and investors can gain peace of mind in volatile currency markets.

Example: Consider a U.S. exporter expecting payment in euros for a product to be delivered in three months. To protect against the risk of the euro depreciating against the U.S. dollar, the exporter purchases euro call options. If the euro indeed depreciates, the exporter can choose not to exercise the options and execute the spot market at a more favorable rate.

Option Strategies for Hedging

Several option strategies can be employed for multi-currency hedging, each tailored to specific risk profiles and objectives:

1) Long Call Options: This strategy involves buying call options to hedge against currency depreciation. It allows the holder to benefit from currency appreciation while limiting potential losses to the premium paid for the options.

2) Long Put Options: The long put option strategy is used to hedge against currency appreciation. By purchasing put options, the holder gains protection from currency depreciation while having the potential to benefit if the currency appreciates.

3) Collar Strategy: A collar involves simultaneously buying a put option to limit downside risk and selling a call option to finance the put’s cost. This strategy is suitable when a hedger wants to protect against extreme currency movements without significant upfront costs.

4) Risk Reversal: In a risk reversal, a hedger simultaneously buys a call option and sells a put option on the same currency, both with the same expiration date. This strategy is used when the hedger is more concerned about downside risk but is willing to forgo some upside potential.

Example: A multinational company with significant exposure to the Japanese yen anticipates an upcoming payment. To protect against a potential yen depreciation, the company purchases yen put options. At the same time, it sells yen call options to offset the put option’s premium cost. This collar strategy limits the company’s currency risk while still benefiting from favorable currency movements.