Hedging, and a deeper look into the types of Financial Hedges

One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. This is not true!

At the end of the day, there are two different types of hedges: natural hedging and financial hedging. It is not uncommon for companies to use one or both methods to implement their hedging strategies in order to protect their bottom line from currency risk.

Natural hedging involves reducing the difference between receipts and payments in the foreign currency. For example, a New Zealand firm exports to Australia and forecasts that it will receive A$10 million over the next year. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm’s expected exposure to the Australian Dollar is A$7 million. By implementing natural hedging techniques, the New Zealand firm borrows A$3 million, while subsequently increasing acquisition of materials from Australian suppliers by A$3 million. Now, the New Zealand firm’s exposure is only A$1 million. If the New Zealand firm wanted to eliminate nearly all transaction costs, it could open up production in Australia entirely.

Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.

Forward contracts allow firms to set the exchange rate at which it will buy or sell a specified amount of foreign currency in the future. For example, if a New Zealand firm expects to receive A$1 million in excess of what it forecasts to spend every quarter, it can enter a forward contract to sell these Australian Dollars, at a predetermined rate, every three-months. By offsetting the A$1 million with forward contracts every month, nearly all transaction costs are eliminated.

Currency options tend to be favorable for those firms without solidified plans, i.e., a company that is bidding on a contract. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Upfront costs are common with currency options, which can deter small- and medium-sized firms, but the costs are for good reason: currency options allow firms to benefit from favorable exchange rate movement. Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Exchange rate volatility can affect a company’s hedging strategy – the next post will cover why timing is key.

Hedging Basics: Swaptions

Interest rate options are excellent tools to use to mitigate interest rate exposure.  One robust structure that is used to reduce exposure to monthly periods of interest rate volatility is the interest rate swaption.  This instrument combines the protection of a swap, with the flexibility of a European style option.

Interest Rate Swap
An interest rate swap is a fixed for floating swap which allows an investor or corporate treasurer to reduce their exposure to interest rates by selling or buying a swap.  A pay fixed swap reduces exposure to climbing interest rates while a pay float swap reduces exposure to declining interest rates.

European Option
A European style option is an option in which the purchaser of the option can only exercise the option on the expiration date.  The option is the right but not the obligation to purchase a financial instrument as a specific date in the future.  The strike price is the price at which the buyer and seller of the option agree to buy/sell the financial product.

Interest Rate Swaption
An interest rate Swaption is the right but not the obligation to purchase an interest rate swap on a specific date.  On the expiration date, the owner of the swaption has the right to purchase the swap at the strike price.  A swaption payout profile is similar to a European option.

Hedging Basics: Average Price Currency Options

Late last year we started a series of educations posts relating to the fundamentals of currency hedging. This latest post covers the basic workings of Average Price Currency Options.

The currency markets are volatile markets in which movements between currency pairs can be swift and choppy, changing the direction during political uncertainty or during statement by central banks on monetary policy.  Many treasurers have significant exposure to the currency markets, and hedging using daily operating currency rates can be a significant help in smoothing a corporation’s cash flows.

Average Price Option
An average price option, which is also known as an Asian option, is a financial instrument in which the payout is calculated based on the average price through a specific period.  The period in question can range from a couple of days to multiple years.  Average price options help a treasurer hedge their exposures to the currency markets on a daily basis, removing the daily volatility associated with currency fluctuations.

Average Price Option Payout
Average price currency options generate a different payout profile when compared to European and American style options.  An average price option is calculated by averaging a specific currency rate either using the end of the day price or a mutually agreed upon point, over the period in which the option is active.  For example, a monthly average price option would use the daily average of the trading days during the month.  This level is compared to the strike price, and the difference when multiplied by the volume generates the payout.

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.

Hedging Basics: FX Hedging Using a Currency Put

Currency hedging is a financial exercise in which a treasurer will mitigate their exposure to directional currency movements in an effort to smooth returns or stabilize cash flows. One of the easiest and most effective ways to hedge a currency position is to purchase a protective put, which will offset any losses below a specific strike price.

Put Option Basics
A currency pair put, is the right but not the obligation to sell a designated currency pair at a specific strike, on or before a certain date.  The exchange rate that the parties that transact a currency put is referred to as the strike price, while the date when the option expires is called the expiration date.  European style currency options allow the owner of a put to exercise the put only on the expiration date while American style options allow the flexibility to exercise the option on or before the expiration date.

The Payout of a Currency Put
The payout a currency hedger receives from the purchase of a put is the difference between the spot market of a currency and the strike price of the option at the time the option is exercised.  Options can be settled on a physical basis, where actual currency changes hands at the strike price exchange rate or on a cash basis where one party makes a payment to its counterparty.

When to use zero-premium FX collar options as the method of hedging

For importers and exporters managing trade-related transactional FX exposures, the choice of hedging instrument is just as important to overall performance as tactical/strategic risk management decisions to position at the minimum or maximum of hedging policy limits. Increased volatility in many currency pairs over recent years has naturally increased option premium costs, however it is not wise to always hedge via zero-premium collar options and never consider paying premium to buy outright call and put currency options. The choice between these option instruments and straight forward exchange contracts normally comes down to the following considerations:

  • If the home currency spot rate is at an historical low point against the export receipt currency (say based on long-term average rates) and the lead-indicators point to a greater probability of appreciation of the home currency than further depreciation, the choice of hedge instrument is going to be heavily weighted to straight forwards.
  • If the home currency spot rate is at an historical high point against the export receipt currency (based on long-term average rates) and the lead-indicators point to a greater probability of depreciation of the home currency than further appreciation, the choice of hedge instrument is more likely to be buying outright call options on the home currency.
  • When the currency pairs are trading closer to long-term average levels and there is no clear indication on future direction either way, collar options fulfill the objective of being hedged at an acceptable rate (the cap), however leaving some opportunity to participate in favorable market rate movements at least down to the collar floor level.

In some respect, hedging with collars is akin to having permanent orders in the market to deal at more favourable exchange rate levels with protection on the other side along the way. Whilst zero-premium may appear attractive, FX risk managers should always examine the trade-off’s of paying some premium to widen the gap between the floor and cap strike rates to provide greater opportunity of participation in favourable rate movements. In a similar vein, opportunities should be taken to restructure collars over the course of their term by buying back the sold cap or floor, or alternatively converting the collar to a straight forward if original target hedged rates are achievable. An active mixture of hedging instruments within policy limits should provide greater opportunity to beat benchmark and budget exchange rates.

Roger Kerr is widely regarded as one of New Zealand’s leading professional advisers and commentators on local/international financial markets, the New Zealand economy and corporate treasury risk management. Roger has over 30 years merchant and investment banking industry experience, and has been closely associated with the changes and development of New Zealand’s financial markets since 1981. Roger advises many Australian and New Zealand companies in the specialist areas of foreign exchange risk, interest rate and funding risk and treasury management policy/governance matters.

Roger has provided daily market and economic commentary on the 6.40am slot at radio station NewstalkZB since 1994.