MULTINATIONAL companies and investors face a wide variety of currency exposures which can be hedged using currency options.
Swiss Bank Corp (SBC,) one of the leading providers of derivatives' instruments in Hong Kong, has prepared a guide to currency options and how they work to insulate companies and investors from risk.
SBC said the currency risks faced by multinationals typically included transaction exposure, where current period cash flows were exposed to fluctuations in foreign currencies; translation exposure, where consolidated results were affected by changes in exchange rates between consolidation dates; contingent exposure, where deals which might fall through were exposed to fluctuations in rates; and economic exposure.
Currency options give the holder the right, but not the obligation, to buy or sell a currency. To hedge an exposure, companies aim to take a position in the options' market which balances their exposure to an unfavourable currency movement.
Unlike in the futures or forward markets, companies' losses in the options' market are limited to the prices they have paid for their options.
Using forward and futures' contracts, companies are able to hedge their exposure almost exactly so that profits or losses on the forwards or futures are matched by profits or losses on the underlying currency.
This, in effect, locks in an effective rate of exchange for the hedger.