Foreign exchange market is always exposed to various risks like exchange rate risk and interest rate risk. Market volatility gives rise to sudden emotional decisions, which may not practically seem to coincide with the benefits as anticipated. Many look at FX trades as speculative way to make dollars, while many others utilize the market to cover up their other exposed risks. Hedging is commonly noticed in many Forex trades.
While forward contracts were looked at as best hedging instrument against interest rate risk, FX Options (Known as “Currency Options) have paved their way to establish themselves as a favorable choice. FX options are flexible compared to the forwards, as they give the buyer a choice, not an obligation, to exercise his right of the contract. The buyer however gets this “choice” only on a payment of an upfront “premium” to the seller of the option.
Hedging with Currency Options
Traders use currency options to protect themselves against the adverse & volatile movements in the exchange rates. For instance, when the investor speculates that the USD/YEN rate will surge higher, it simply means that he would need to pay extra Yen to get one USD compared to what it was previously,
Hence the investor would buy a “Call Option” on USD/YEN. This way he is “hedging” or protecting his position from the risk of increasing rate of USD/YEN. Through the call option, he can exercise his right when the price increases and thus not let his other position affect.
Lets take one more example of an investor, who is long (holds the position) on stock of Microsoft and expects the market to go down in the near future. But, he doesn’t wish to sell his position abruptly. So to hedge his risk against the volatility of the stock price, he can buy “Put Option” on Microsoft stock. If the price falls in the future, he can exercise his option and sell his position for a price higher than the spot price.
Considering the volatility of the foreign exchange market, an investor needs to have hedging instruments that are highly liquid. Currency options are highly liquid and hence are considered as a good hedging instrument. As the investor need not exercise his option, it is regarded as an “insurance” or “protection” on the market positions.
Tit-bits of Currency Options hedging
Currency options are mostly sold on OTC (over-the-counter) markets. Multinationals and corporations use currency options to hedge the risks related to their export and imports. Often in any export-import trade, the payment is delayed and such a delay could result in inadvertent loss to the investor. Hence, currency-hedging turns out to be a good opportunity to avoid unfavorable losses, yet make favorable gains. Many, as a hedging tool in foreign exchange trades, also use currency forwards and futures. But these tools are rigid as compared to the flexibility of the currency options. Hence, hedging with currency options is seemingly the right choice to protect against the market risks.