A custom-tailored hedge can offer maximum protection
MULTINATIONAL companies and investors face a wide variety of currency exposures which can be hedged using currency options.
Swiss Bank Corp (SBC,) one of the leading providers of derivatives' instruments in Hong Kong, has prepared a guide to currency options and how they work to insulate companies and investors from risk.
SBC said the currency risks faced by multinationals typically included transaction exposure, where current period cash flows were exposed to fluctuations in foreign currencies; translation exposure, where consolidated results were affected by changes in exchange rates between consolidation dates; contingent exposure, where deals which might fall through were exposed to fluctuations in rates; and economic exposure.
Currency options give the holder the right, but not the obligation, to buy or sell a currency. To hedge an exposure, companies aim to take a position in the options' market which balances their exposure to an unfavourable currency movement.
Unlike in the futures or forward markets, companies' losses in the options' market are limited to the prices they have paid for their options.
Using forward and futures' contracts, companies are able to hedge their exposure almost exactly so that profits or losses on the forwards or futures are matched by profits or losses on the underlying currency.
This, in effect, locks in an effective rate of exchange for the hedger.
According to SBC, forwards and futures are a better choice than options for hedging purposes when the hedger is certain about the future movement of exchange rates.
''When there is uncertainty about the direction of currency rate movements, options are likely to be a more attractive hedge instrument than forwards or futures. Options make it possible to control downside risk while at the same time benefitting from favourable market movements,'' SBC said.
Options are also better when the deal giving rise to the foreign exchange risk is not finalised - a common situation in world finance.
For example, if a company has put in a bid for a contract in a foreign currency, it is unwise to use forwards or futures to hedge its exposure.
If the company does not win the contract, there will not be any cash flow from the underlying contract to offset any losses realised on the hedge markets.
Using options, the company can limit its losses in hedging to the price of the option.
Options are divided in those traded over the counter (OTC) and those traded on exchanges. Exchange-traded options offer advantages in terms of market information, but OTC options are more flexible, according to SBC.
''Large deals are usually done more effectively and more and different currencies are covered in the OTC markets than in exchange-traded markets. There is also more confidentiality in dealing in OTC markets than in going through exchanges,'' SBC said.
