Forex Options and Other Financial Instruments for a Tailored FX Risk Management Strategy in Forex Trading

Put-Call Parity: Fundamental to Combining Forex Options for Effective Hedging

Key to understanding the forex options strategies described below for FX risk management is the underlying fundamental principle of put-call parity. This defines a reliable relationship between options and forward contracts which can help businesses when choosing appropriate hedging strategies to suit their circumstances. Put-call parity says that simultaneously buying a European call option and writing a European put option on the same currency pair, with the same strike price and expiration date, is equivalent to purchasing a forward contract on that currency pair with the same expiration and a forward price equal to the option’s strike price.¹

To demonstrate this principle, imagine an Australian farmer is selling lamb three months forward to a British meat importer. He expects an inflow of British pounds in three months’ time, so wants to hedge his exposure in case the Australian dollar exchange rate versus the pound rises during that time. He can enact a forward contract to purchase Australian dollars and sell British pounds three months forward at today’s price of 0.62. In three months’ time, he will be obliged to buy AUD and sell GBP at that price, regardless of how the exchange rate has moved in that time.

Alternatively, he can obtain the same protection by simultaneously buying a European AUD-GBP call option and selling (“writing”) a European AUD-GBP put option, both expiring in three months’ time and both with a strike price of 0.62 (this is “at-the-money”). In three months’ time, if the exchange rate has moved to 0.60, the call option expires unexercised, but the put option is exercised at 0.62. Similarly, if the exchange rate has moved to 0.64, the put option expires unexercised but the call option is exercised at 0.62. Either way, the farmer is obliged to purchase AUD and sell GBP at 0.62 – exactly as if he had enacted a forward contract. Such a structure is known as a “synthetic forward,” because it synthetically re-creates the characteristics of a forward contract.²

Put-call parity means that a purchased call option is equivalent to a written put option for the same currency pair, expiration date and strike price: similarly, a purchased put option is equivalent to a written call option. Whether to purchase or write an option depends on the view of exchange rate movements. A purchased option has limited risk and potentially unlimited reward, while a written option has limited reward and potentially unlimited risk. Purchasing an option thus takes a negative (“bearish”) view of exchange rates, while writing an option takes a positive (“bullish”) view. It is easy to assume that because of the potentially large losses and limited rewards from writing options, they have no place in a hedging strategy. But in fact, limiting a strategy to purchased options (a “long only” strategy) can make hedging more expensive and less effective than strategically combining purchased and written options.³

 

Tailored Hedging Using Forex Options and Currency Forwards

Call and put options can be combined to create hedges to suit particular needs. Typically, these combinations work for companies that want to manage cash balances in multiple currencies so as to gain from beneficial FX movements while minimizing notional losses from adverse movements. Following are some commonly used combinations.

A long straddle combines a purchased call and purchased put option in the same currency, with the same strike price and expiration date.⁴ If the currency depreciates, the call option will be in-the-money (and therefore the company will purchase currency). If it appreciates, the put option will be in-the-money (and therefore the company will sell currency). Effectively, this combination enables the company to switch between two currencies depending on the direction of the exchange rate. It is useful for a company that wishes to manage its FX exposures actively and has no pressing cashflow needs.

For example, consider an Australian exporter that is selling regularly to the U.S. and the U.K. It is a cash-rich company so has no particular need to convert its receipts in USD and GBP to Australian dollars on receipt. It observes that the GBP-USD exchange rate is somewhat volatile, so it sets up a straddle which enables it to convert its GBP balance to USD when the GBP-USD exchange rate rises, and convert its USD balance to GBP when the exchange rate falls. By doing this it can benefit from GBP-USD exchange rate movements in either direction.

A short straddle combines a written call and written put option, providing a similar currency switch while enabling the business to profit from the option premiums. However, it is a riskier strategy, since a large movement in the exchange rate could result in large losses.⁵

A strangle is similar to a straddle except that the strike price of the two options is different – usually, the call option has a higher strike price than the put option. A long strangle can be a cheaper cashflow hedge than a long straddle, but it allows the exchange rate to fluctuate more and therefore does not fully protect against FX losses on the currency switch.⁶

A (long) strap is a combination of two purchased call options with a purchased put option, all with the same strike price and expiration. It is effectively a straddle with double the upside potential. A (long) strip is a combination of two purchased put options with a purchased call option, again all with the same strike price and expiration. A strap is a bullish bet on a big currency move: a strip is a bearish bet. Both can be constructed with written options, gaining the company income from premiums, but this is a riskier strategy and the potential losses could be very large.⁷

A call option bull spread involves buying a call option while simultaneously writing a call option in the same currency pair for the same expiration at a higher strike price. It is essentially a bet that the currency will appreciate modestly. There is no downside risk, since if the currency does not appreciate the option will expire. The business benefits from the premium on the written option; but if the currency appreciates a lot, there are potentially large losses.⁸ Similarly, a call option bear spread involves buying a call option while simultaneously writing a call option in the same currency pair for the same expiration, but this time at a lower strike price. This is a bet that the currency will depreciate modestly. It carries the same benefits and risks as a bull spread. Bull and bear spreads can also be created using put options.⁹

Synthetic forwards can be helpful for smoothing cashflow. In an outright forward, the eventual settlement is at the forward price on expiry. Conversely, in a synthetic forward, there is likely to be an initial margin and the net position will be cash settled daily (variation margin); if the option is properly priced, the eventual settlement should be entirely covered by the margin posted.¹⁰

Companies working in multiple currencies sometimes adopt a mixed FX risk management strategy involving both forward contracts and options.Generally speaking, a forward contract works best when a currency’s exchange rate is fairly stable, while options are better for more volatile currencies. One large European bank evaluated the benefits of using 50 percent forward contracts, 50 percent forex options for major developed country currencies, and a higher proportion of forex options for developing country currencies. It concluded that there was a cost benefit from using a proportion of forward contracts for major currencies over an entirely option-based strategy.¹¹

 

The Takeaway:

Businesses can combine forex options to create FX risk management strategies tailored to their needs. Option combinations can be particularly useful for businesses with multiple currency exposures, since it can help them to take advantage of exchange rate movements between the currencies in which they deal. Forex options can also be combined with forward contracts to create a cost-effective hedging strategy for multiple currency exposures. However, combinations can be risky: short positions, particularly, may need careful management. Tailored hedging with forex options is not suitable for all businesses.

 

Sources

1. “Put-Call Parity Definition,” Investopedia; http://www.investopedia.com/terms/p/putcallparity.asp#ixzz4aGrAFoPW
2. “Synthetic Forward Contract,” Investopedia; http://www.investopedia.com/terms/s/synthetic-forward-contract.asp
3. “Managing currency risks with options,” CME Group; https://www.cmegroup.com/trading/fx/files/ManagingCurrencyRisksWithOptions.pdf
4. “Currency option combinations,” Madura; http://www.cengage.com/resource_uploads/downloads/0324288417_68116.pdf
5. Ibid
6. Ibid
7. “Strap options”, Investopedia http://www.investopedia.com/articles/active-trading/071514/strap-options-market-neutral-bullish-strategy.asp
8. “Currency option combinations,” Madura; http://www.cengage.com/resource_uploads/downloads/0324288417_68116.pdf
9. Ibid.
10. “Synthetic forward and put-call parity,” Actuarial Files; http://www.actuarial-files.com/examples/parity.pdf
11. “Hedging: Combining Options with Forwards,” Commerzbank; https://fim.commerzbank.com/CorporateRisk/EN/FXTransactions/files/assets/basic-html/page38.html