In this piece, we discuss how exotic forex options can help to provide longer-term “structured” protection as part of a sophisticated foreign exchange risk management strategy. Structured products are customized combinations of two-to-many underlying elements, such as an option and a forward contract, designed with a particular goal in mind; in the case of FX risk, the goal is to simultaneously mitigate a set of complex risks. This article assumes familiarity with option terminology and a knowledge of how forex options work. Readers unfamiliar with these may wish to read our FX options basics explainer before proceeding.
Companies with exposure in multiple currencies may wish to hedge their overall FX exposure. One way of doing this is with a forex option on a basket of currencies rather than trying to hedge each currency pair individually.1 Suppose a London-based company is exporting to the U.S., Australia, Canada and France, and needs to hedge FX exposure on its trading accounts in all four currencies. The company can purchase an Asian put option on a basket of these currencies.2 The basket could be an index, such as the USFX futures contract, or – more likely – the currencies will be chosen by the buyer. The currencies in the basket can be “weighted” by their importance to the buyer’s business.
Asian options, also known as “average rate options,” pay out according to the average price of the underlying assets (in this case, the four currencies) during the contract period.3
An alternative to an Asian option might be a “lookback” option. Rather than determining the payout by the average price during the lifetime of the option, a lookback option determines payout by the peak average price reached by the currencies in the basket. This would be the lowest purchase price in the case of a call, and the highest sale price in the case of a put.
Another possibility is a “ratchet” option. Also known as “cliquet,” this type of option locks in gains on the basket of currencies based on a time cycle, such as monthly, quarterly, or semi-annually. This is accomplished by determining the average price level of the currencies on predetermined anniversary dates. “Ladder” options are similar, except that the gains are locked in when the price reaches a pre-agreed level rather than on a particular date.
Currency warrants issued by investment banks can be useful for managing longer-term exposures in multiple currencies. Like options, warrants confer the right but not the obligation to buy (or sell) the underlying currency. They may be issued for a currency index, a basket of currencies or a single currency pair. Warrants are tradable instruments for which there is usually a liquid market, so a position involving warrants can be easier to unwind than one involving OTC options.
For situations where there is extreme near-term business uncertainty followed by more typical foreign exchange risk, compound options can be useful. In a compound option, the payoff is another option. There are four types of compound options:
So, for example, consider a British company that is bidding for a contract in the U.S. for which it would be paid in U.S. dollars in a year’s time, and is worried that the sterling-U.S. dollar exchange rate may rise during that time. It could purchase a vanilla GBP-USD call option to hedge its potential future US dollar income stream should it win the contract. But if it loses the contract, it would incur the premium cost to no avail. So, it could enter into a three-month call-on-put option to give it time to negotiate. If the call option expires in-the-money and the company has won the contract, the company will then have a put option for its future US dollar income stream with a strike price of whatever was agreed when the call option was enacted three months before: the option will have nine months left to run. However, if the company has lost the contract it can let the call option expire unexercised even if it is in-the-money, unless it has other reasons to hedge US dollar currency risk.4
Another way of managing near-term uncertainty can be to use “chooser” options, where the buyer determines the characteristics of the option at some point during the lifetime of the option contract. For example, an option contract might have a 30-day “choice” period during which the buyer can decide whether the option will be a put or a call, what the strike price will be, and perhaps even set the option expiry date. At the end of the 30-day period, the writer of the option must agree to the terms set by the buyer. This can be regarded as a kind of “option on an option,” with the first option being an American-style option to set the terms of the next. This type of option is generally quite expensive because of the flexibility afforded to the buyer.
Businesses making investments using foreign currencies – for example, buying a subsidiary in a foreign country – may wish to hedge the forex element of their investment. “Quantos” are a type of stock option where the purchase or sale of the underlying stock is settled in a different currency than that in which the stock is denominated, and then exchanged at a rate agreed up front. Quantos can be regarded as a stock option with an embedded forward contract. The forward contract has a fixed rate but a variable notional amount – hence the name “quanto,” which is short for “quantity adjusting option,” where the quantity that is adjusting is the value of the underlying stock.
There is a large and growing range of forex options and warrants that can help provide structured protection for longer-term and uncertain forex exposures. As with all FX hedging tools, these instruments tend to shift risk rather than eliminating it, and they can put capital at risk. They are not suitable for every business. But for sophisticated international businesses with complex FX risk management needs, they can be a useful addition to the forex hedging toolkit.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Basket options,” FINCAD http://www.fincad.com/resources/resource-library/wiki/basket-options
2. “Exotic Options – An Overview,” National University of Singapore ;http://www.stat.nus.edu.sg/~stalimtw/MFE5010/PDF/L1hand0.pdf
3. “Asian Option,” Investopedia http://www.investopedia.com/terms/a/asianoption.asp
4. “Call on a put,” Investopedia http://www.investopedia.com/terms/call-on-a-put.asp