Often regarded as the most difficult to understand aspect of foreign exchange, options can be great tools to have in your business’ currency management kit once you understand what they can do.
The global financial crisis and resulting recession across Europe and the USA has caused extreme volatility in currency markets over the last 18 months. Australian exporters who earn revenue in foreign currency have been severely impacted by wild fluctuations in these currency markets. Increasingly, Australian exporters are turning to currency options to hedge their currency exposures, but like all hedging tools, these products have their strengths and weaknesses.
A currency option gives the buyer of the option the right, but not the obligation, to buy or sell a currency at an agreed rate for a future date. Currency options can be simple vanilla types such as a ‘call option’ or a ‘put option’. However, there are many types of options available and complex financial engineering strategies can be devised using a combination of different option products.
A key point to remember for exporters is that the more complex an option structure becomes, the more expensive it becomes. Also with increased complexity, the harder it is for exporters to understand their risk exposures and calculate the value of the option structure. Many exporters will not have adequate systems in place to calculate either.
Call option
This is an option where the buyer has the right, but not the obligation, to buy a currency at a set rate on a future date. Exporters, for example, could use an AUD/USD call option to protect their profit margins by buying the right to buy AUD/USD on a future date.
Example: An exporter has contracts where they expect to receive US$1 million by April 30, 2010. Buying an option is a good idea if the current spot AUD/USD rate is 92 cents and the exporter is concerned the AUD/USD may rise before April 30 and wishes to protect the profit margins.
The exporter may then buy a 95-cent call option for expiry on April 30, 2010. If the spot AUD/USD is above 95 cents at expiry, the exporter will exercise his right to buy AUD/USD at 95 cents. If the spot rate is lower than 95 cents, the exporter will allow the option to expire, and buy the AUD/USD at the prevailing spot AUD/USD rate.
Strengths: Profit margins protected at 95 cents, with unlimited downside potential if the AUD/USD rate should experience sustained weakness by maturity.
Weakness: Exporters will be charged a premium to buy the option, which is non-refundable, affects cash flow and adds to operating costs.
Put option
This is an option where the buyer has the right, but not the obligation, to sell a currency at a set rate on a future date. Importers, for example, could use an AUD/USD put option to protect their profit margins by buying the right to sell AUD/USD in the future.
Zero cost option
This option is a structure that is a combination of both a call and a put option, also known as a collar option. An exporter using this method would buy a call option, and at the same time sell a put option. The cost of the call option, which protects the exporter from a rising AUD/USD, is offset by the premium earnt from selling the put option.
Example: If a spot AUD/USD rate was 92 cents, the exporter may buy a 95-cent call option, while selling a 90-cent put option. At maturity, if the AUD/USD is above 95 cents, the exporter exercises the right to buy at the lower rate of 95 cents. If the AUD/USD is below 90 cents, the buyer of the put option will exercise their right to sell the AUD/USD. If the AUD/USD is in between 90 cents and 95 cents, the exporter allows the options to expire, and simply does a spot transaction at the prevailing rate.
Strengths: Zero cost means the strategy can be put in place with no upfront premium. The exporter has complete protection both sides of the market and can work out profit margins, revenue generation and budget projections.
Weakness: Should the AUD/USD rate weaken sharply, the exporter is unable to take advantage of that as the purchaser of the 90-cent put option will exercise their option to sell AUD/USD at 90 cents should AUD/USD be lower at expiry.
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