Using Options to Hedge Currency Exposures

Many corporations tend to use forwards to hedge their currency exposures - pricing is relatively transparent, the accounting simple and most finance staff are comfortable with them. They do have some limitations; among them, the fact that a forward is a firm commitment. If the underlying exposure no longer exists (e.g., a foreign sub is shut down, a contract cancelled, etc.), the forward contract must still be honored or cancelled, which could involve a loss. They are also inflexible; they work best when currencies move in the direction of the hedge, but offer no upside when currencies move in favor of the underlying exposure. Many corporations that hedged emerging market currency payables in 2008 have discovered this to their chagrin. Their payables have shrunk in USD terms, but they have a large mark-to-market loss on their hedges, which negates most if not all that potential gain. Could using option-based hedging strategies have helped in this scenario? Perhaps...

Buying a simple currency call or put is very different from entering into a forward - there is protection without commitment, complete flexibility, but the premium must be paid upfront and can be substantial. In recent months, as volatility has surged in equity, bond and currency markets, the cost of buying options has risen as well. As an example, implied volatility on three-month EUR options has gone from eight or nine percent in early 2008 to well over 20 percent recently, more than doubling the cost of buying the option. INR option volatilities have moved even more dramatically, from around six percent to well over 30 percent; anyone that bought INR calls earlier this year to hedge payables would have laughed all the way to the bank. The relatively cheap options would have expired worthless, allowing the company to buy INR in the spot market and realize a huge opportunity gain. The currency has weakened from under 40 per USD early this year to over 50 per USD in early December. Had the same company used a forward instead, the initial contract price would have presumably locked in a lower rate around 40, not permitting the company to reap any of the gains of INR depreciation.

There are many other option strategies that can be employed that are less flexible than purchasing a simple option, but are also less expensive. Using the INR example above, buying an INR risk reversal or collar (buy an INR call, sell an INR put, both out of the money) or an INR participating forward (buy an INR call and sell an INR put, both with the same strike but varying principal amounts) would probably have led to a more favorable result than a forward, with the benefit of 20-20 hindsight. There are many other possibilities that I cannot explore in this article, but any trained salesperson or trader would be happy to help explain them.

In general, forwards are best suited for companies that want cheap, effective hedges and are not overly concerned with opportunity losses. For those that want more upside participation or flexibility, or face greater uncertainty in their business, some form of option strategy might be the way to go. For both groups, it may be worth exploring a range of strategies that includes forwards, options and hybrid structures, before settling on one approach. Make sure that all stakeholders understand the strategy and its risks and are comfortable the strategy is in compliance with the company's internal foreign exchange hedging policy. Accounting for hybrid structures and ensuring compliance with FAS 133 can often be more complicated than for forwards and hence all accounting issues should be addressed and resolved before adopting the strategy.

Looking Ahead

My core view is unchanged; I expect the dollar to weaken further in the near term and have little or no bounce later in 2009. I am basing this on my view that we are in for a prolonged economic slowdown, which will result in aggressive quantitative easing by the Fed. As I pointed out last week, that combination resulted in a weak JPY for many years when Japan faced similar problems in the 1990s and I expect much the same for us.

I expect the EUR to retest the 1.47 to 1.50 level over the next couple of months, but probably fall short of last year's high near 1.60. It has been the main beneficiary of recent dollar weakness, but the European economy is slowing rapidly. More interest rate cuts are likely, which should result in a period of consolidation for the currency.

The GBP has weakened dramatically vs. the EUR on concerns about the UK economy and the prospect of rates falling well below one percent from the current two percent. Despite being oversold, the currency could test 1.40 vs. the USD and parity vs. the EUR before recovering later in 2009.

The JPY is likely to remain firm in the near term, but not strengthen significantly unless risk appetite plummets again. Longer term, it should underperform other major currencies when and if the global economy recovers in late 2009.

Commodity currencies should do better as global growth and, hence, commodity prices stabilize. They have been pummeled in recent months, but have recently shown signs of some stability. The AUD is perhaps best positioned to do well. The CAD could underperform somewhat; despite better economic fundamentals, it is likely to be negatively impacted by the U.S. economy in 2009.

The stronger Asian currencies should strengthen when the global economy recovers; their fundamentals are sound, reserves adequate and growth rates higher than most other regions. Eastern Europe has struggled recently and I expect that to continue in 2009.