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Explaining Options for Managing FX Risk, From the Basics to the Straps & Straddles

By Frances Coppola

Some businesses don’t pay attention to foreign exchange risk, while most of those that do rely on forward contracts to actively manage it. But there are many additional tools designed to help businesses manage the risks caused by the ever-rising volatility of foreign currency exchange rates.

In this five-part series, financial journalist Frances Coppola, regularly featured in the Financial Times, The Economist, Forbes and a range of other financial industry publications, explores the theory and practice of currency options, also known as forex options, from the simple basics to the exceedingly complex (and their sometimes bizarre-sounding names).


Part 1: Explaining Basic Currency Options for Managing FX Risk


Forex options provide an additional tool for foreign exchange risk management, alongside other commonly used tools such as forward contracts. They are financial derivative products, actively traded by currency speculators, that confer the right but not the obligation to buy or sell currency at an agreed exchange rate. While FX options are simple in principle, their pricing can be complex. Familiarity with the terminology and the basic principles of options trading may be helpful when understanding ways to hedge FX risk in international business. Read Article


Part 2: Using Exotic Forex Option Structures for FX Risk Management


Many businesses find their FX risk management needs can be fully met with currency forwards and “vanilla” forex options. Others go further, to so-called “exotic options” that have non-standard features enabling them to be tailored to individual risk management needs. Using exotic options as part of an FX risk management strategy can help businesses to keep hedging costs down and manage complex risks effectively. But take care: using options to hedge FX exposure does not eliminate risk, it merely changes its nature. Read Article


Part 3: Using Exotic Forex Options to Reduce Hedging Costs in FX Risk Management Strategy


Some businesses use exotic options to reduce their hedging costs as part of a well-considered FX risk management strategy. Sharing the benefits (if any) of a forex option instead of paying a fee is one strategy for doing so. Another is conditional activation, involving products like knock-in options (up-and-in or down-and-in) and knock-out options (up-and-out or down-and-out), which activate only when a trigger rate is reached. Exotic options typically put the company’s capital at some risk, and are not suitable for all businesses. But for some, they can provide effective FX hedging at lower cost than simple forward contracts and vanilla forex options. Read Article


Part 4: Structured Protection for Businesses with Sophisticated FX Risk Management Needs


In today’s uncertain world, international businesses have a growing need to manage currency volatility and multiple FX risk exposures effectively. Part 4 explores how exotic forex options can help to provide longer-term “structured” protection as part of a sophisticated foreign exchange risk management strategy. As with all FX hedging tools, these instruments tend to shift risk rather than eliminate it, and they can put capital at risk. But for sophisticated international businesses with complex FX risk management needs, they can be a useful addition to the forex hedging toolkit. Read Article


Part 5: Combining Forex Options and Other Financial Instruments for a Tailored FX Risk Management Strategy


Part 5 explores how businesses can combine options and other instruments for more effective FX risk management strategies tailored to their needs. It explains the fundamental principle of put-call parity; and how combining options can be particularly useful for businesses with multiple currency exposures, since it can help them to take advantage of exchange rate movements between the currencies in which they deal. This is where we describe long and short straddles, strangles, straps, strips, bull spreads, bear spreads, and synthetic forwards. Proceed with caution: with maximum customization comes the highest risk. Read Article


Frances Coppola - The Author

The Author

Frances Coppola

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.

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