Currency Options
HEDGING WITH CURRENCY OPTIONS
The objective of including currency options in your hedging arsenal has obviously to be to get the best protection available at the least possible cost. This is easier said than done. However, a corporate with foreign currency payables say in euro could use the following decision tree as a guide:
Currency hedging decision tree.
View of currency View of risk Action
Very bullish Risk averse Buy currency forward
Very bullish Risk tolerant Buy currency forward
Bullish Risk averse Buy currency forward
Bullish Risk tolerant Buy atm call
Flat market Risk averse Buy ootm call
Flat market Risk tolerant Do nothing *
No view Risk averse Buy atm call
No view Risk tolerant Do nothing *
Bearish Risk averse Buy ootm call
Bearish Risk tolerant Do nothing *
Very bearish Risk averse Buy far ootm call
Very bearish Risk tolerant Do nothing *
Notes:
* : Place good-till-cancelled stoploss orders just in case the currency strengthens unexpectedly.
atm = at-the-money
ootm = out-of-the-money
What is important to bear in mind is that options should be considered as complementary to forwards and not used to the exclusion of forwards. Even so once a decision is taken to hedge with options, one has to decide on the strike price and the maturity based on the expected direction of the market, volatility and also interest rates if hikes or cuts are imminent.
Another area is to consider the use of range forwards and participating forwards as also exotic options such as knock-ins, knock-outs, etc. In these cases, the option buyer’s main goal is to reduce or totally avoid the upfront premium payable in the case of plain call or put options. However, it should be borne in mind that for reducing or avoiding the premium, the hedger gives up a part of the protection and /or benefit. In the case of knock-in options, he...
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