Hi there,
I have a question regarding the currency risk and options used to hedge it.
Which option (generally speaking) and why is used more often by international firms to hedge against the currency risk? American or European style option? What are the pros and cons of each of them in relation to the currency risk?
I would be very grateful if you could share your thoughts on this…
Thanks, Michael
A company can encounter two “types” of currency risk:
A) Accounting loss from exchange rates movement. Example: Company A operates in USA but is England-based. Company A uses USD as functional currency and borrows USD 500 million (also sells in USD and pay coupons in USD), however it reports financial statements in GBP. By the time USD/GBP convertion ratio changes, company A can bear a loss that is accounted in its GBP financial statements. Those “losses” are from a pure accounting translation. No money has been wasted.
B) Economic loss from exchange rates movement. Example: Company B operates in USA and is USA-based, uses USD as functional currency (sells and spend on USD) and borrows JPY 54,000 million because it is way cheaper to borrow on yens and not in USD. Company B every 3 months has to sell USD and buy YEN to pay bondholders’ coupons. In this process, Company B losses money when buying yens at an unfavorable rate vs the original exchange rate at bond issuance.
In both cases a company can make use of derivatives to reduce currency risk, however in case A) the meaning is less optimal than in case B). The decision to buy derivatives in case A) will depend on which type of company we are talking about. A public company will be forced by public scrutiny to hedge currency risk despite it will not generate economic losses, but indeed will do by buying the derivative (option premium) regardless the scenario (accounting loss or gain from exchange rate movement). A private company is not dependent on public scrutiny and will probably not hedge as long it is just an accounting loss from exchange rates movement.
More into your question, as you see, the company can buy american or european style options. Commonly, companies are not the speculative type so they will buy the cheapest option that fits its requirement: european style.
American options give you the right to exercise the contract at any time between purchase and expiration of the option, so they are more expensive than european options because european can only be exercised at expiration giving you less probability of getting a profit from the hedge (net of premium).
for scenario b, and from what i have read, companies are more concerned with the average exchange risk over time - up and down price fluctuations average out over time. these companies, or so i heard, may choose to buy exotics instead of standard american or european options. being long a strip of puts can be expensive and not very cost effective. instead, the companies could be long an arithmetic asian, with the strike being the current exchange rate. this allows them to hedge against the average exchange price while also saving them on option cost. they could hold barrier options, where the underlying put option only knocks in if the exchange rate drops significantly.
Right, I have seen several call spread contracts among corporative companies. The cheapest and also effective.
This is helpful! Very much appreciate thank you