Hedging with Foreign Currency Options
Moving beyond stocks and indexes, options can also hedge against a different type of risk: currency exchange rate risk. Currency hedging scenarios are frequently tested, and the logic follows a simple rule once you learn it.
Currency Option Basics
- Foreign currency options are used to hedge currency exchange rate risk by corporations with international operations, importers, exporters, and investors with foreign holdings
- Contract sizes are standardized:
- Most currencies: 10,000 units of the foreign currency per contract
- Japanese yen: 1,000,000 units per contract (because yen are worth much less per unit)
- Foreign currency options are physically settled: exercise results in delivery of the actual foreign currency
- Listed on exchanges (primarily the Philadelphia Stock Exchange, now Nasdaq PHLX)
Exam Tip: Gotchas
- Foreign currency options are physically settled (actual currency delivery), unlike index options (cash-settled).
- Japanese yen contracts are 1,000,000 units, not 10,000. The exam may test this distinction.
The Core Hedging Rules
The key to currency options is one simple question: Will you need to BUY or SELL the foreign currency?
| Scenario | Hedge | Rationale |
|---|---|---|
| U.S. exporter expecting to receive foreign currency | Buy puts on the foreign currency | Protects against the foreign currency weakening (falling in dollar terms) |
| U.S. importer needing to pay in foreign currency | Buy calls on the foreign currency | Protects against the foreign currency strengthening (rising in dollar terms) |
| U.S. investor holding foreign securities | Buy puts on the foreign currency | Protects against the foreign currency depreciating relative to the dollar |
Memory Aid: Receive = puts, pay = calls
- If you are going to receive foreign currency (and convert to dollars), buy puts: you want the right to sell the currency at a known rate
- If you need to pay in foreign currency (and must buy it with dollars), buy calls: you want the right to buy the currency at a known rate
Exam Tip: Gotchas
- An investor holding foreign securities has the same exposure as an exporter (will receive foreign currency when selling). Hedge with puts.
Full Hedge vs. Partial Hedge (Currency)
- Buying an option provides a full hedge (maximum protection) at the cost of the premium
- Selling an option provides only partial protection equal to the premium received
| Action | Hedge Type | Cost |
|---|---|---|
| Buy currency put (exporter) | Full hedge | Pay premium |
| Sell currency call (exporter) | Partial hedge | Receive premium |
| Buy currency call (importer) | Full hedge | Pay premium |
| Sell currency put (importer) | Partial hedge | Receive premium |
Think of it this way: Buying an option is like buying insurance: you pay a premium upfront, but you are fully protected if the exchange rate moves against you. Selling an option is like collecting an insurance premium: you pocket cash now, but your protection only covers a small amount (the premium received).
Exam Tip: Gotchas
- Selling currency options provides only partial protection equal to the premium received. Only buying provides a full hedge.
Example Scenarios
Scenario 1: U.S. Exporter
A U.S. company will receive 500,000 euros in 90 days. If the euro weakens against the dollar, the dollars received will be less than expected.
- Hedge: Buy 50 euro put contracts (50 x 10,000 = 500,000 euros)
- If the euro falls, the puts gain value, offsetting the currency loss
- If the euro rises, the puts expire worthless, and the company benefits from the stronger euro (minus the premium paid)
Scenario 2: U.S. Importer
A U.S. company must pay 200,000 British pounds in 60 days. If the pound strengthens, the cost in dollars increases.
- Hedge: Buy 20 pound call contracts (20 x 10,000 = 200,000 pounds)
- If the pound rises, the calls gain value, offsetting the higher cost
- If the pound falls, the calls expire worthless, and the company benefits from cheaper pounds
Exam Tip: Gotchas
- When a currency option expires worthless, that is the best-case scenario for the hedger (the currency moved in their favor). The premium paid is the cost of protection, similar to an insurance policy you never needed to use.
- To calculate the number of contracts needed, divide the total currency exposure by the contract size (10,000 for most currencies, 1,000,000 for yen).