Currency Risk And How To Cover It With Options

“Currency Risk and how to cover it with options”

Exchange Risk was defined as covering those situations where a clear obligation to make or a right to receive, a payment in a foreign currency has arisen . In others words the period of risk ends when the final payment or when final receipt of the foreign currency is done.

Nowadays the majority of companies and industries related to imports and exports, this means those companies which do their business with foreigners, they are exposed at the exchange risk because they have to pay o receive the money in different currencies (Contractual flows are in currency) and that is produced by the exchange rate . For example, an Ecuadorian company is the supplier of a Japanese company therefore; the supplier has to receive the payment in 30 available days. We have to consider that during this period of time both companies are suffering the exchange risk. Both have two possible situations at the day that Japanese company gives the payment to the other one because of the exchange rate fluctuations in this case Yen/Us dollar. By the side of the Ecuadorian company, the risk is that domestic currency (US dollar) loses its value hence Japanese company will give less Yens. This scenario could be dangerous for the Ecuadorian company because after they have received the money, they would have to change it to US dollar and will have fewer dollars than expected. The most probable is that this money will not be sufficient to cover all the cost they had. On the other hand, if the domestic currency gains value against the Yen, Japanese company will give more Yens. Obviously this is a benefit for the Ecuadorian company because when Ecuadorians change it to US dollar, they will have more than expected and the most probable is this money will be enough to cover the costs and also to have a profit. By the side of the Japanese company is almost the same as in the first case Japanese will give less Yens, hence, they will have a profit, and with an appreciation of the foreign currency (US dollar), Japanese will give more money that it is a kind of lost for them. For that reason, they have had to find a solution to reduce it and this is called currency hedging.

There are different kinds of hedge such as hedges with forward contracts, hedges in the money market, hedges with futures and hedges with options. This last mentioned is the one I will explain and write about in this paper .

The risk consists that at the moment companies receive or pay their cash flows the spot exchange rate will be different than expected for example; if we have an account to pay in foreign currency the spot exchange rate will be higher than expected. On the other hand, if we have an account to receive in foreign currency spot exchange rate will be lower than expected. At first, we use expectations for make a decision but it is important to understand that results are known after when the effective exchange rate is already known. This explanation is illustrated in Figure 1.

Merton Miller argued that the exchange coverage only reduces the specific risk of the company, does not reduce the systematic risk. Due to the fact that the risk premium required by investors is proportional with the systematic risk, coverage does not reduce the capital cost, therefore, does not contribute to increase the corporate value.

In sum, the objective of a hedging program is to ensure that the company has enough flows to do the strategic plan and also to guarantee the company to have money when they need it. The advantages of exchange coverage are illustrated in Figure 2.

Regarding the different kinds of hedges that I have already mentioned except the last one, it is important to say that they eliminate the exposure to exchange risk with no possibilities of obtaining profits. Otherwise, there are some people who want to eliminate the currency risk without renouncing to a potential profit. In these cases the options appear. The option type is used depending on the expectation of the buyer, it means if he hopes the exchange rate increases, he may buy a call option but if he expects the rate decreases, he may buy a put option.

The advantages of the hedging with options are:

• Do not eliminate the potential of profit.

• The exercise prices are multiples.

• The exercise is optional

The disadvantages of the hedging with options are:

• The premium is not an immediately disbursement and it is not recover if the option is not executed.

• The premium can be expensive .

There are two components to know in the options and they are: Premium and the strike . Premium is the cost of the option and the strike is the exercise price of the option.

When we obtain a call option or a put option there are two parts involved: the first is the one who has to pay a premium to the second one, buyer and seller respectively. It could be a little confused, maybe you are saying but what is the difference?

A call option gives the fund manager the right, but not the obligation,

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