Currency Hedge
Over the few decades, the financial markets have seen explosion in the derivative markets. Even though notable investors such as Warren Buffet has called derivatives as the weapon of Mass Destruction’’, still, derivatives accounts for a market worth trillions of dollars as companies around the world use these instruments to hedge their risk exposures. Below we have discussed three traditional derivative instruments and how they are used by the companies to hedge their foreign exchange exposure:
Currency Forwards:
Currency Forwards are the derivative contracts as part of which, one party agrees to buy a predetermined amount of one currency for a certain amount of another currency at a fixed date. Accordingly, as soon as the parties enter the forward contract, an exchange rate is fixed and the other party can buy a fixed amount of currency underlying the contract. For instance, assuming ABC Inc. expects to receive EUR 50 Million in 90 days from now and in order to hedge against the currency exchange risk, it enters into a currency forward contract to exchange Euros for US Dollars at 1.23 per euro. Assuming that at the date of settlement, the exchange rate is 1.21 per euro, in this case:
Amount to be received under forward contract
50 million euro* 1.23= $61.5 million
Amount to be received without forward contract
50 million euro* 1.21= $60.5 million
Therefore, by hedging the currency exchange risk, ABC Inc. earned a gain of $1 million and most importantly, it was also able to hedge its exposure.
Currency Futures:
Currency Future are very much like Currency Forwards as part of which, two different parties agrees to buy/sell the specified currency at a predetermined rate. However, unlike forward contracts, currency futures are highly standardized and are traded on organized stock exchanges. Additionally, clearing houses are also established to safeguard the interest of both the parties. Important to note, in the present day corporate scenario, the currency hedging is done through future contracts only as not only both the parties are safeguarded from default risk because of the presence of the clearing house. Moreover, since currency futures contracts are marked-to-market on the daily basis, investors are able to exit their position even prior to the delivery date.
Currency Options
Currency option is yet another derivative instrument and is one of the most popular method through which corporate hedge their currency risk exposure. By entering the currency option, the company obtains the right, but not the obligation, to buy or sell the currency at a pre-determined exchange rate decided at the time of purchasing the currency option. However, in order to purchase the currency option, the company is required to pay the premium, which is decided by the exchange. Important to note, there are four possible currency option position available for an entity:
Long Call: Buyer of the call option, i.e. the investing company, buys the right to purchase the underlying currency
Short Call: Seller of the call option, i.e. the investing company, has the obligation to sell the underlying currency
Long Put: Buyer of the put option, i.e. the investing company, obtains the right to sell the underlying currency
Short Put: Seller of the call option, i.e. the investing company, has the obligation to buy the underlying currency
For instance, assuming a US based entity believes that USD/EUR rate will decrease and expects the USD to appreciate, in this case, it will purchase long call option on USD/EUR.
References
Hull, John. Options, Futures and Other Derivatives. Prentice Hall, 2009.
