FX Forwards Vs FX Options
In previous articles we have talked about why corporates should hedge their FX exposure, looking at the risks presented by the uncertainty of exchange rate movements within a business context. We have also looked at some of the different options available to corporates regarding their hedging needs and how FX forwards and FX options are two of the most popular and effective tools for hedging FX exposure. However, you might still be wondering what the difference between the two are and which one is best or if either is. So, in this article we’re going to break what these two contract types are (lightning quick refresher course in case you’ve forgotten) and more importantly, why you would use either contract, discussing benefits and risks.
What Are FX Forwards?
An FX Forward contract agrees on a pre-determined exchange rate for a transaction at a pre-determined future date. The contract is binding meaning that at the future date specified, the currency exchange will take place. Now, this can be a very beneficial tool for corporates looking to hedge their FX exposure as it allows them to agree on a rate ahead of time. So let’s say a company a European company is due to make payment in US dollars for imports 3 months down the line, using forwards allows them to agree a fixed rate which means that if the US Dollar strengthens against the Euro during that time, they won’t be negatively impacted by the movement. However, the contract also means that if EUR strengthens against USD during that period, the company won’t experience the benefit of the stronger domestic currency. So as you can see, there are pros and cons to be considered.
What Are FX Options?
An FX option is a very different fish. This contract type is not obligatory in that the price agreed for the contract can be exercised or it can be waived. So, let’s say a company is European company is due to make the USD payment three months down the line but they are worried that the USD is going to strengthen, meaning their costs will go up. EURUSD is trading 1.20 at the time. The company might choose to hedge this exposure by buying a put in EURUSD at 1.18. This means that three months from buying the option, the company can exercise the option and sell EURUSD at 1.18 if it wishes. If EURUSD has crashed to 1.10, this would be a very lucrative option indeed and would help offset the increase in costs from the rise in USD. Alternatively, if EURUSD remains above 1.18 at the time of expiration, the company can choose not to exercise the option, merely losing the premium they paid on the contract.
Which Is Better?
So, the question now is, which is better? Well, the good or bad news is that neither is objectively BEST. The benefits of each contract type depend on the specific corporate needs in question. If you feel like nerding out, there are plenty of research studies online which seek to answer this question and there are plenty of papers supporting both contract types individually. However, let’s look at the scenarios and motivations for which each contract type might be more appropriate.
When to Use Forwards
Perhaps the most important consideration when determining which contract type to use is with regard to cash flows forecasts and how much certainty is involved. For corporates dealing with certain cash flows, e.g a payment of X amount due on date X, forwards offer a better measure of protection as the company is able to agree on a specific rate for the transaction ahead of time. FX forwards offer much more specific risk: reward profiles.
When To Use Options
However, if the company is dealing with a more uncertain cash flow issue such as end-of-year foreign earnings (which will need to be repatriated) options provide a little scope than forwards. The binding rate agreement of FX forwards means that the company will only benefit where the market moves in line with their expectations. However, as options offer the right but not the obligation to be exercised at a certain price there is room for the company to benefit if correct in their forecasts, but also the ability to back out of the deal (losing only the premium paid) if incorrect.
Blending the Two
For many corporates, ultimately, a blend of the two contract types will be used to help most effectively manage foreign currency exposure. As discussed, for issues where the cash flow forecast is certain, such as payments and receivables, FX forwards can provide a clear cut way of managing the downside risks. For issues with more uncertain cash flow forecasts, such as hedging end-of-year earnings, mergers and acquisitions or even sale of fixed assets, options can provide a more beneficial structure for dealing with the relevant currency risks.