Foreign-exchange Option - Hedging

Hedging

Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.

Suppose a United Kingdom manufacturing firm expects to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm loses money, as it will receive less GBP after converting the US$100,000 into GBP. However, if the GBP weakens against the US$, then the UK firm receives more GBP. This uncertainty exposes the firm to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.

If the cash flow is uncertain, a forward FX contract exposes the firm to FX risk in the opposite direction, in the case that the expected USD cash is not received, typically making an option a better choice.

Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which:

• protects the GBP value that the firm expects in 90 days' time (presuming the cash is received)
• costs at most the option premium (unlike a forward, which can have unlimited losses)
• yields a profit if the expected cash is not received but FX rates move in its favor

A 'free-lunch' option is an option that has been stripped out into a prop book for zero cost and offers the trader a chance to lock in a huge payout if the underlying trades through the strike as it will not be delta hedged. It is a very popular term used globally and an essential part of a FX Option trader's terminology handbook.