Hedging Basics: A Currency Pair Risk Reversal

One of the most interesting strategies that can be used by investors or treasurers to hedge their exposures to the currency markets is a risk reversal.  This type of option structure will hedge a currency pair by protecting against the downside with a put option and financing the put purchase with the sale of a call option.  If a business wanted to hedge an upside directional move in a currency pair they would structure a risk reversal in which they purchased a call and sold a put option.

Call Option Basics
A currency pair call is the right (but not the obligation) to purchase a currency pair at a specific strike, on or before a certain date.  The exchange rate that the parties that transact a currency call is referred to as the strike price, while the date when the option expires is called the expiration date.  The strike prices for the currency call and currency put generally straddle the market price.

The Payout of a Risk Reversal
A business that is protecting against a downward adverse move in a currency pair can use a risk reversal by selling a call and purchasing a put with strike prices that are above and below the market price respectively.  Some attempt to offset the entire cost of the put with a call making the structure a zero cost risk reversal.

If the currency pair at expiration is below the put, the business will receive the difference between the strike price and the price at expiration multiplied by the volume of currency describe in the put option.  If the price of the currency pair is above the call, the business will need to pay away the difference between the strike price and the market price at expiration multiplied by the volume described in the option contract.

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