19 November 2007: Hedging Currency Risk

The investor can react to foreign exchange risk in one of two ways. One alternative is to do nothing. In this case, the investor is left with foreign exchange risk and retains either the gains or losses from the currency exposure. The alternative is to hedge or not and, if so, how much to hedge and when can be complex. The choices depend on how much volatility the investor is exposed to, how much volatility can be reduced, how much it costs to hedge, what expectations the investor has for foreign exchange movements, and what trade-off the investor is willing to make between the reduction in volatility and the cost of the hedge.

For the investor who has decided to hedge some part of the foreign exchange exposure, there are three typical hedge alternatives. The first is the symmetrical hedge using forward or futures contracts to minimize both currency gains and losses. A matched hedge uses the same currency to hedge as the investor is exposed to. A currency-basket uses a portfolio of currencies to hedge the investor's exposure; the portfolio is configured in such a way as to reduce the expected hedging cost while minimizing the tracking error of the hedge.

The asymmetrical hedge uses options. The asymmetry of options is designed to preserve some gains from currency exposure while protecting against losses. The two most common option strategies are the protective put and the range forward or collar. The protective put is generally the most expensive protection, but it preserves the majority of the gains from favourable currency exposure. The range forward (collar) is a somewhat less expensive alternative; it lowers the cost by capturing the gains from favorable currency exposure only up to a certain level.

The final hedging alternative consists of active management of the hedge. In this strategy, currency exposure is left unhedged when currency returns are expected to be unfavorable. The goal of active hedge management is to capture the benefits of hedging while paying as little as possible for the protection. One might think of it as trying to create the same results as a protective put while minimizing the cost of the put option. Effective active hedge management requires a systematic, on-going evaluation of potential changes in foreign exchange rates.

Both forward and option contracts derive their value from the level of the underlying exchange rate, the relative interest rates between the two countries, and the time to maturity of the contracts. The price of an option also depends on the strike price of the option and the estimated volatility of currency returns.

Forward and Futures Contracts. The pricing of foreign exchange forward and futures contracts is driven by the covered interest arbitrage relationship. Although the two types of contracts contain important differences, they can be treated as equivalent for purposes of pricing.

The fair value forward or futures price is:

Current forward Forex rate = Current Spot Forex Rate (1 + Annualized domestic interest rate x time till expiration)
1 + Annualized foreign interest rate x time till expiration

A foreign exchange futures or forward contract calls for future delivery of a specified amount of foreign exchange at a fixed time and price. The buyer of the contract has the obligation to receive the foregin exchange amount; the seller has the obligation to deliver the specified amount.

In the United States, the majority of foreign currency futures contracts are traded in Chicago on the International Monetary Market (IMM), which was organized in 1972 as a division of the Chicago Mercantile Exchange. Since 1985, contracts traded on the IMM have been interchangeable on the Singapore International Monetary Exchange.

Currency futures contracts have standardized features in order to concentrate trading liquidity into common size and maturity specifications. IMM currency futures contracts follow a quaterly expiration cycle with expirations on the third Wednesday in March, June, September, and December.

Futures contract prices are quoted American style (USD/FX), and the purchase or sale of one contract on a particular currency corresponds to the associated contract size. Gains and losses caused by changes in the futures prices are settled on a daily basis between individual investors and the exchanges through the brokers.

For example, suppose an investor purchases 100 futures contracts on the Japanese yen at a price of 0.0100 USD/yen (100.0 yen/USD). If the yen appreciates from 0.0100 to 0.0101 USD/yen (0.99 yen/USD), the investor will gain US$125,000 (that is 100 contracts x (0.0101 - 0.0100) x Y12,500,000 per contract).


Standard foreign currency option contracts have the following features:

• The option contract gives the option purchaser the right (but not the obligation) to buy or sell a given amount of foreign exchange in the underlying currency at a fixed price per unit (strike or exercise price) within a specified period of time (set by the maturity or expiration date).
• A call option gives the investor the right to buy the foreign currency; a put option gives the investor the right to sell a foreign currency.
• An American option gives the buyer the right to exercise at any time up to the exercise date; a European option can be exercised only on the expiration date.
• The cost of the option is usually referred to as the option premium.
• Options on futures contracts give the buyer the option to purchase currency futures contracts instead of the underlying currency itself.
• The intrinsic value of an option depends on the relationship between the strike price and the exchange rate of the underlying currency, A call option has an intrinsic value equal to the maximum of zero or the difference between the underlying exchange rate and the exercise price. A put option has an intrinsic value equal to the maximum of zero or the difference between the strike price and underlying exchange rate.
• An option with a positive intrinsic value is said to be 'in the money'. Options with no intrinsic value are said to be 'out of the money'. An 'at the money' option is one whose strike price is equal to the underlying exchange rate.

Currency Option Markets. Foreign currency options are available in three markets in the US:

• Options on the physical currency in the over-the-counter (interbank) market;
• Options on the physical currency on organised exchanges;
• Options on futures contracts at the IMM in Chicago.

The most common over-the-counter (OTC) options written by banks are for US dollars against the British Pound, the Euro, Japanese yen and Swiss franc. The size, maturity, and strike price of the options can be tailored to meet the specific needs of the investor, and the market is quite liquid for transactions in multiples of US$5-$10 million. OTC options do expose the investor, however, to counterparty risk - the risk of the bank not being able to fulfill its obligation in the option contract.

In the OTC market, option prices are typically quoted as a percentage of the home currency amount of the transaction evaluated at the strike price of the option in home currency units. For example, a put option to exchange US$41,875,000 for NZ$62,500,000 at an exchange rate of 0.67 NZD/USD quoted at 1.76 percent would cost US$737,000 (that is, 0.0176 [US$41,875,000]), which is equivalent to quoting the option as a percentage of the exercise price of the option in home currency units. When considered in this way, the cost of the option would also be US$737,000 (that is 0.0176 [0.67 x NZ$62,500,000], where 0.67 x NZ$62,500,000 or US$41,875,000 represents the home currency value of the strike price).

Options on the underlying physical are traded on several exchanges around the world. In the United States, the greatest volume is traded on the Philadelphia Stock Exchange. The exchange clearing house serves as the guarantor behind the options contracts, and members of the clearing house bear the financial responsibility. Expiration months are March, June, September, and December plus the two nearest additional months to the contract date. Each option expires on the Saturdayu preceding the third Wednesday of the expiration month.

The number of exchange-traded options needed to cover a particular amount of foreign exchange is calculated by dividing the amount of foreign exchange by the amount covered by each option.

Options on futures contracts are traded on the IMM. Options are available on the futures contracts that expire according to the quarterly expiration cycle (March, June, September, and December), but the futures options carry monthly expiration dates. As a result, an investor can purchase option contracts on the March futures contract, for example that will expire in January, February, and March. Options expire two Fridays before the third Wednesday of the expiration month. As the exchange-traded options on the physical currency, prices for futures options are quoted in cents per unit of the foreign currency.

Synthetic Option Positions. The return effects of an option can be mimicked by using futures or forward contracts to adjust the hedge ratio in a systematic way as exchange rates move. Selling more futures contracts as the