You should give a forex
Hedging on currency markets offers relatively pain free protection against world events and now it is cheaper than ever
ASK any finance director and they will tell you that their company is not in the game of speculating in the foreign exchange markets. Better to concentrate on core business and let the dealers in banks worry about the vagaries of the money markets.
Since the ability to hedge future currency risk has existed for many years through the use of Forward Forex Contracts, it is perhaps surprising that many companies still elect to deal in the spot (two day delivery) market at the point when their currency cashflows fall due. In the current geopolitical and economic climate, where it is impossible to predict rate movements with any degree of confidence, it is not over-stating things to suggest that these unhedged exposures are a direct form of speculation.
Although this spot practice still exists, a fair percentage of Scottish companies are prudent in their risk management through their use of forward contracts – hedging as soon as exposures are known or highly probable, and quantifiable. Forward contracts are popular as they guard against negative currency fluctuations and deliver what companies set out to achieve. They do suffer from one major weakness: companies cannot participate in a favourable exchange rate movement.
Forex options offer this flexibility and economic benefit. The concept may not be new but their diversity and cost-effectiveness certainly is, and worthy of further investigation. There is no doubt that forex options have suffered poor press in the corporate sector as there is an upfront premium to pay and, consequently, they are perceived as being expensive. But, over the years, banks have addressed this objection by structuring options which reduce or even eliminate the upfront premium.So how do they work?
There is a dazzling array of products with strange names that seem designed to bamboozle and turn off the very clients they would like to attract: knock-ins, knock-outs, risk reversals, participating forward options, and many more. They sound complex but on closer inspection are fairly intuitive and do not require in-depth technical knowledge to be understood.
Crucially, they are excellent ways of increasing a company’s bottom-line through participation in a positive rate movement. By being prepared to give up a percentage of a favourable move, a company can enjoy a reduced premium or nil premium hedging strategy. Another feature of options is that they are an ideal vehicle to hedge uncertain exposures such as tendering for contracts or anticipated but not yet confirmed sales.
If the contract is required, the underlying exposure is already covered – if not then there is the ability to walk away from the option leaving the premium as the only cost, which was always known. In addition, there may be the opportunity to sell the option or gain from a positive move.
Content supplied by Caroline Donald, Corporate Treasury Services, Anglo Irish Bank