Mitigating risks with FX options
Is there a direct relationship between your FX exposures and the resulting P&L effects? Have you ever thought about hedging with FX options instead of FX forwards but then ruled it out? Here are some reasons why it might make sense to give this idea a second thought.
When hedging foreign currency exposures, most corporates have traditionally relied on FX forwards. FX options have often been perceived as a more expensive means of hedging FX risk. They also have a reputation of being less effective for hedging, since the exact level of cover and hedged FX rate are not certain until the options expire. A lack of transparency about the quotes on more structured FX options provided by banking counterparties has also been a concern for corporates when considering FX options. It’s very easy to check in real time the price of an FX forward on a Reuters or Bloomberg screen – or even on any website – but (structured) FX options quotes are not readily available.
Uncertain underlying exposure
Despite these concerns, several circumstances and scenarios can make FX options a more attractive and useful tool for mitigating currency exposure risk. This might be the case where the underlying exposure is highly uncertain. Think, for instance, of a big tender process where there is foreign currency risk involved and a company must provide a quote. There is high uncertainty about whether it will win the tender. Costs and margins can potentially be protected by utilizing FX options without the obligation of settling any FX transactions in case the tender is lost.
Another situation where FX options can be more effective than FX forwards is when a corporate has a market view in the sense that FX rates are not likely to move against it. For example, a USD appreciation when an entity with EUR as its functional currency is expecting to purchase goods in USD. In this example, hedging with FX options would still give protection if the USD strengthens against the EUR. Conversely, in case its vision on the EUR/USD trend becomes certain and the USD weakens, the corporate would benefit from the downside movement and buy USD cheaper.
Regulation is another factor that might help FX options become a more popular hedging instrument among treasurers in the coming years. For corporates applying IFRS 9 hedge accounting, the premium paid on the options can now be treated as a ‘cost of hedging’, which, in essence, means that it can be posted in OCI rather than in P&L. This was not allowed under IAS 39.
Corporates have several alternatives to reduce the premium cost. For instance, a company could enter into a deep ‘out of the money’ option – i.e. setting a strike rate that is far away from the current market rate. This strike rate would typically be the worst possible rate that the company is comfortable with, according to its budget rates objectives. Another alternative to reduce the cost might be by selling another option. The premium received would offset – totally or partially – the premium paid. This strategy would give protection to the company on the downside. It would also allow it to participate in the upside potential until the strike rate of the written option.
In summary, FX options – typically combined with FX forwards to build a diversified hedging portfolio – can be useful instruments to achieve the objectives stated in the risk management policy of a company.