Exploring FX derivatives: forwards vs options

As more firms embrace currencies to protect and enhance their competitive position and profit margins, it is a good time to reconsider the main types of financial instruments at their disposal to remove currency risk. These instruments are called FX derivatives because their value depends on the level of the underlying currency rate.The main types of FX derivatives include forwards and futures, swaps and options. Before looking at forwards and options in more detail, it is important to emphasise that FX risk management does not always necessarily involve the use of FX derivatives.Consider the case of a firm that uses automated solutions to protect its budget rate with conditional FX orders, delaying the execution of hedges while monitoring markets 24/7. Delaying hedge execution allows the treasury team to take advantage of netting opportunities, which actually reduces the need for using FX derivatives.Plus, companies can reduce the cost of hedging in the event of unfavourable interest rate differentials between currencies. All the while, no FX derivatives transactions are executed. The point of these remarks is simple: FX risk management is more than just the act of buying or selling a financial instrument.

FX derivatives: forward contracts

A currency forward transaction is similar to a spot FX transaction in that it entails buying one currency against payment of another. But there is a key difference. Whereas spot transactions call for delivery and payment to take place within a maximum of 48 hours, forward transactions are settled after 48 hours.In fact, forwards can be negotiated for a few weeks, a month, six months, a year and even more in the most liquid currencies. The market for currency forwards is said to be OTC (Over-The-Counter), that is, transactions take place in largely unregulated markets between dealers. In a typical forward transaction, a Japanese company buys textiles from England with a payment of £1 million due in 90 days. The Japanese importer is ‘short’ British pounds because it owes pounds for future delivery. As the GBP-JPY exchange rate will shift during this time-lapse, the importer can guard against the underlying currency risk by negotiating a 90-day forward contract with a bank.

This currency forward creates a ‘long’ position in pounds that offsets the ‘short’ position from the commercial agreement. Aside from the fact that spot FX rates and forward rates exchange are not equal (see: Forward Points Optimisation), the fact is that fluctuations in the GBP-JPY exchange rate create FX gains and losses.FX gains and losses in commercial and in derivatives transactions go in the opposite direction from one another. They offset each other (-/+ the forward points impact), thereby removing currency risk. This is precisely what constitutes a currency hedge. The mutually offsetting FX gains and losses reflect the linear payoff structure of currency forwards.

FX derivatives: currency options

Currency options give the buyer the right to buy or to sell one currency against payment of another. So-called ‘plain vanilla’ options include simple call-and-put options that can be used on their own or as part of combinations that provide great flexibility.In currency options, a ‘long’ call gives the buyer the right, but not the obligation, to buy a given currency in exchange for another at a predetermined exchange rate (known as ‘strike price’ or ‘exercise price’), in exchange for another currency until (or at) the expiration of the contract.A long ‘put’ option has a similar structure, but it gives the holder the right to sell the currency instead. The right to exercise a call or put option comes at a cost: a premium must be paid to the option seller. The value of an option reflects its intrinsic value and its time value. A call (put) option has intrinsic value if the exchange rate is above (below) the strike price.The timevalue, in turn, reflects the probability that, upon expiration, the option will have an intrinsic value. It depends therefore on the volatility of FX markets and on the time left to expiration. The higher the volatility of the underlying exchange rate, and the longer the maturity of the contract, the higher the time value of the option.Thus we can see that, unlike with forward contracts, options payoffs are not symmetric.

Advantages and disadvantages in the context of automation

When using financial derivatives to manage currency risk, companies must assess the tools that are better suited to their own particular purposes. Some of the considerations to be weighed by treasury teams include:

• The symmetry of payoffs (or lack thereof)
• The degree of financial constraint (when paying premiums)
• The degree of forecasting accuracy

It has been argued, for example, that the flexibility that comes from currency options leaves companies in a better situation to avoid scenarios of over-hedging. This phenomenon occurred on a large scale in 2020 as firms that hedged large forecasted exposures with currency forwards overestimated the volume of business.Yet, this point seems to ignore recent developments in technology. Most automated FX hedging programs can nowadays be configured in a way that reduces the need for very precise forecasting accuracy. For example, tour operators in the travel industry need to hedge hundreds or even thousands of transactions per year.Because this was not possible in the age of manual execution, these firms had to rely on dubious forecasts. Now, technology makes it possible for them to handle any number of FX forward transactions, in any desired currency pair. And because hedges are executed on the back of firm orders, there is no real need for super-accurate forecasts. In other words: Currency Management Automation is putting to rest managers’ concerns about over-hedging risk. Currency forwards with symmetric payoffs (an advantage over currency options) can be deployed without managers losing sleep over their degree of forecasting accuracy.Is technology tilting the debate in favour of currency forwards, at a time when financially constrained firms baulk at disbursing cash to pay for being ‘long’ currency options? This is certainly an intriguing possibility.