Learning Outcomes
After studying this article, you will be able to identify currency risk and explain how currency options can hedge foreign exchange exposures. You will distinguish between calls and puts, outline the benefits and limitations of options compared to other hedging techniques, and apply basic option strategies to common corporate scenarios for the ACCA Financial Management (FM) exam.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand the recognition and management of currency risk using currency derivatives, including options. This article focuses on:
- The types of foreign currency risk faced by businesses (transaction, translation, economic)
- How currency options operate as hedging tools
- Comparing currency options to traditional hedging strategies (e.g., forwards)
- The mechanics, benefits, and cost factors of call and put options in currency risk management
- Applying basic option strategies to typical exam scenarios
- Evaluating when options may be preferable to other hedging methods
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the key difference between a forward exchange contract and a currency option for hedging a foreign exchange receipt?
- Which of the following best describes a currency put option?
a) The right to buy currency at a fixed rate
b) The obligation to sell currency at a fixed rate
c) The right, but not the obligation, to sell currency at a fixed rate
d) The obligation to buy currency at a market rate - State one scenario where it may be more advantageous for a company to use a currency option, rather than a forward contract, to hedge foreign exchange risk.
- List two limitations of using currency options as a hedging strategy.
Introduction
Currency fluctuations can create risk for firms dealing in foreign currency transactions. Proper identification of risk and effective hedging are critical to avoid unexpected losses that may arise between contract and settlement dates. While forward contracts are widely used, currency options provide flexibility and can sometimes better match a firm’s risk profile, particularly in uncertain situations.
Key Term: currency option
A financial derivative giving its holder the right, but not the obligation, to buy (call) or sell (put) a specified amount of foreign currency at a predetermined rate on or before a fixed date.
Types of Foreign Currency Risk
Firms can face several types of risk due to currency movements:
- Transaction risk: The risk that exchange rate moves between a transaction and its settlement affect the domestic currency value.
- Translation risk: The impact of exchange rate changes on the reported value of foreign assets, liabilities, or subsidiaries in group accounts.
- Economic risk: The long-term risk that exchange rate changes will affect the present value of future cash flows or competitive position.
Key Term: call option
The right, but not the obligation, to buy a specified amount of foreign currency at a fixed rate on or before a stated date.Key Term: put option
The right, but not the obligation, to sell a specified amount of foreign currency at a fixed rate on or before a stated date.
Overview of Currency Options
Currency options offer flexibility by allowing the user to benefit from favourable exchange rate movements, while still providing protection against adverse changes. They are particularly useful when the timing or certainty of foreign receipts or payments is unclear, or where the business wishes to retain the opportunity to benefit from positive currency movements.
How Currency Options Work
- Option holder: Has the right to exercise the contract if it is advantageous. They may let the option expire if the market rate is more favourable.
- Option writer: Has the obligation to fulfil the contract if the holder chooses to exercise.
- Call options: Used by firms facing a future foreign currency payment—they hedge against the currency appreciating.
- Put options: Used by firms expecting to receive foreign currency—they hedge against the currency depreciating.
Options may be purchased "over the counter" (OTC), tailored to firm needs, or traded on exchanges in standard contract sizes and expiry dates.
Cost of Options
The option buyer pays a premium upfront, regardless of whether the option is ultimately exercised. This premium compensates the writer for bearing potential risk. Premiums are influenced by factors such as:
- Volatility of the currency
- Option duration
- The distance between the option strike price and the current spot rate
Comparing Options and Forward Contracts
A forward contract fixes the exchange rate for a future transaction, with a binding legal obligation. An option provides the right, but not the obligation, to exchange at a fixed rate—if the market moves favourably, the option can be abandoned (apart from the sunk cost of the premium).
Worked Example 1.1
A UK-based exporter expects to receive $500,000 in three months. The current spot rate is $1.30 = £1. They are considering either a forward contract at $1.29 = £1 or purchasing a put option with a strike price of $1.29 = £1 at a premium cost of £3,000. In three months, the spot rate could be $1.25 = £1 (dollar weakens) or $1.35 = £1 (dollar strengthens).
Question: Compare the outcomes for the forward hedge and the option hedge under both scenarios.
Answer:
- Forward contract: Locks in $500,000 / 1.29 = £387,597, regardless of spot movement.
- Option outcome if spot is $1.25/£ (dollar weakens): Exercise put. £ received = $500,000 / 1.29 = £387,597, minus £3,000 premium = £384,597.
- Option outcome if spot is $1.35/£ (dollar strengthens): Let option lapse and convert at $1.35: $500,000 / 1.35 = £370,370, minus £3,000 premium = £367,370 (worse than exercising). Correction: Because the spot rate is less favourable than the strike, exercising is better at both possible scenarios up to the option's break-even point, so company would always exercise if spot < $1.29. If spot is more than $1.29, convert at market and let option expire; benefit from the upside.
Options provide a minimum guaranteed rate (less the premium), with potential for advantage if market rates move in favour.
When to Use Currency Options
Options are most suitable:
- When future cash flows are uncertain in amount or timing
- When there is a possibility to benefit from upside market movement
- When significant exchange rate volatility is expected
For transactions with significant certainty, low risk, or tight margins, forward contracts may be more cost-effective unless flexibility is specifically needed.
Worked Example 1.2
An importer in Europe needs to pay £250,000 in six months. The current rate is €1.15 = £1. The company is considering a euro call option on pounds with a strike price of €1.16 = £1, at a premium of €5,000. In six months, the spot rate is either €1.11 or €1.20.
Question: What should the importer do in each scenario, and what is the effective euro cost of the payment under each?
Answer:
- If spot is €1.20/£ (pound strengthens): Exercise call. Pay €1.16 × £250,000 = €290,000 + €5,000 premium = €295,000.
- If spot is €1.11/£ (pound weakens): Let option expire. Buy £250,000 at market: €1.11 × £250,000 = €277,500 + €5,000 premium = €282,500. The option sets a cap on euro outlay if the pound rises, while permitting a lower outlay if the pound falls.
Basic Option Strategies
- Full cover: Buy options for the full amount of foreign currency exposure.
- Layered strategies: Buy options up to a "worst case" scenario or combine options with forwards (sometimes called "collars").
- Protective puts/calls: Used to guarantee a minimum (or maximum) rate for large exposures.
Key Term: option premium
The upfront fee paid by the buyer to acquire the rights under a currency option, non-refundable regardless of whether the option is exercised.
Advantages and Limitations of Options
Advantages:
- Flexibility to benefit from favourable currency movement
- Limits downside loss to the premium paid
- Useful under uncertainty
Limitations:
- Premium cost reduces net gain compared to forwards if market is stable or unfavourable to exercise
- Can be more expensive than forwards, especially for longer dates or volatile currencies
- May not be available in all currencies or for all amounts
Worked Example 1.3
A business expects to receive a variable foreign currency amount from a large contract settlement. The final receipt could range from $0 (if the contract is cancelled) up to $2 million. Is a currency option or a forward better for hedging this exposure?
Answer:
- A forward contract is binding and exposes the company to risk if the receipt does not occur (leading potentially to costs from closing or reversing the contract).
- A currency option allows the company to hedge the largest expected amount, but if the amount received is less, the unused portion of the option expires without further cost. The company pays only the premium for this flexibility. Currency options are better suited for hedging uncertain or contingent amounts.
Exam Warning
Remember, currency options protect against adverse movements, but the premium is a sunk cost: do not ignore its impact on net receipts or payments. In multiple choice questions, check carefully whether the option has been exercised, expired, or partially used.
Revision Tip
When comparing hedging methods, always quantify the effect of the option premium and identify if the situation involves upside opportunity or downside protection only.
Summary
Currency options provide valuable flexibility in managing foreign exchange risk. They secure a worst-case exchange rate while permitting gains from favourable movements, unlike forwards. The effectiveness depends on correct identification of exposure, assessment of cost (the premium), and consideration of the company’s risk tolerance and cash flow certainty.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and distinguish between call and put currency options
- Identify scenarios where currency options are preferable to forwards
- Understand how option premiums affect hedging decisions
- Apply option strategies to common hedging scenarios
- Recognise the advantages and limitations of currency options as risk management tools
Key Terms and Concepts
- currency option
- call option
- put option
- option premium