Taking Cover. Options to hedge forex risk

In an earlier article in these columns last month, we had explained how exchange-traded currency futures could be used to hedge foreign currency fluctuation risk if you have forex expenses or are travelling abroad.

Now, we take a look at another instrument that can also serve the same purpose. This is “options,” an instrument that gives the buyer the right but not the obligation to either buy or sell at an agreed price.

The two types of options available are call (option to buy) and put (option to sell). The call option can be used if you want to hedge the currency risk on your forex expenses.

What is a call option? It gives you the right but not an obligation to buy at an agreed price. Let’s say the rupee is trading against the dollar at 63.50 and you anticipate that if it weakens below 64.25 it can fall to 65 and 66.

So, you can buy a call with a strike price of 64.25 for the month of July trading at a premium of ₹0.30.

Now let’s say you buy one lot, which equals $1,000. Then you pay a total premium of ₹300 (0.30*1,000). Strike price is the agreed price at which the option will be executed at the time of expiry, that is, by the end of July in the above example. Premium is the money you pay to the seller of the option.

The value of the premium increases if the market moves in favour of your view and the rupee falls towards 65 and 66. So, by the end of July, if the rupee is at, say, 65.75, you can execute the call option and earn the difference in premium as your profit.

But what if the market goes against your view and the rupee goes up to 61 by the end of July? You don’t have to worry because you don’t have the obligation to execute the call. In this case, you will just lose the ₹300 paid as premium. So, in the case of options, the loss is limited to the premium that you pay, whereas profit is unlimited.

This cap on losses is the major advantage of using an option as opposed to a futures contract for hedging your exposure. Now, even in futures you can limit your loss by using a stop-loss. But as long as you have an outstanding futures position, you will be obliged to mark-to-market your position every day. There are chances of margin calls being made if your loss widens.

Second, a relatively larger amount of money is required for trading in futures. Taking the above example, you required just ₹300 to buy a call at a strike price of 64.25. But to buy one lot of futures contract at 63.50, you would require anywhere between ₹1,900 and ₹3,800 (3 to 6 per cent of the total value of one lot of ₹63,500).

Third, if the time frame you have is short, then options are better. This is because there could be instances when the market remains calm and stuck within a narrow range for a long time. The recent movement in the rupee between 63.30 and 64.30 for about eight weeks now is a good example.

Because the currency is shackled in a range, the next move after a break-out could be swift and sharp. In this case, if you are holding a futures position, there is the risk of making huge and unlimited loss in a short time, if your view goes wrong.

But if the time frame is long, then futures are better because the rollover cost is less when compared to options. But options require you to take a view on the currency level. In the case of options you first have to fix a strike price based on your view of the market and you will also have to factor in the time value. Whereas in futures, you just enter the market at the prevailing price and exit at your desired level.

One more drawback of options is that you have only the US dollar (USDINR) contract to take positions. But in futures you have three more currencies — the euro, pound and the yen, apart from the USDINR contract.

To sum up, if you can take high risks and need a simple instrument, go for futures contract. On the other hand, if you are risk-averse, use options.

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