The options market hedge

If a company has a foreign-currency receivable or a foreign-currency payable, the options market hedge can protect the company from exchange rate fluctuations. By buying a call option on the foreign currency, a US company can lock in a maximum dollar price for its foreign-currency accounts payable. By purchasing a put option on the foreign currency, the company can lock in a minimum dollar price for its foreign-currency accounts receivable.

Companies understand that hedging techniques such as the forward market hedge and the money market hedge can backfire or may even be costly when an accounts payable currency depreciates or an accounts receivable currency appreciates over the hedged period. Under these circumstances, an uncovered strategy might outperform the forward market hedge or the money market hedge. The ideal type of hedge should protect the company from adverse exchange rate movements but allow the company to benefit from favorable exchange rate movements. The options market hedge features these attributes.

To see how currency options provide such a flexible optional hedge against transaction exposure, assume that Boeing exports a DC 10 to British Airways and bills £10 million in 1 year. If Boeing purchases a put option on £10 million, this transaction provides Boeing with the right, but not the obligation, to sell up to £10 million at a fixed exchange rate, regardless of the future spot rate. With its pound receivable, Boeing would protect itself by exercising its put option if the pound were to weaken, but would benefit by letting its put option expire unexercised if the pound were to strengthen.

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