Hedging the risks from writing foreign currency options

EconPapers: Hedging the risks from writing foreign currency options

It agreed to make purchases from Japan, with payment due in yen several months later. The difficulty was that the value of the yen could - and did - swing sharply in those intervening months, altering Apple's dollar costs.

Usually, to hedge such risks, companies agree to buy the yen, marks, pounds or other currency needed several months later at a fixed price in the forward market, paying in dollars.

Apple, however, chose a new hedge, the currency option.

Options are the right to buy or sell a set amount of a currency at a specified date. They eliminate the risk of a loss due to exchange movements, but unlike a forward contract, still give the holder a chance to come out ahead if the currency fluctuations are in its favor. The company's head of foreign exchange operations, Robert Saltmarsh, now speaks of options like a religious convert.

Saltmarsh's enthusiasm sets him apart, but not his interest in this complex financial instrument. There is much questioning in corporate treasuries about how to use them, but it is generally agreed that, for hedging certain kinds of transactions involving foreign currencies, they are better than forward or futures contracts, and that their use will become commonplace. Dillman, manager of options at the Marine Midland Bank, a major operator in the market.

Although the Eastman Kodak Company does not use currency options yet, Eric Nelson, director of foreign exchange planning, said ''They are a terrific foreign exchange management tool and will occupy a significant portion of hedging activity somewhere down the road.

Foreign exchange fluctuations can play havoc with corporate planning.

Hard-won operating gains can be wiped out by the seemingly whimsical turns of the currency market, or profits can be created. But the changes often cannot be forecast accurately. For the past year especially, the market has been a minefield, with the dollar defying predictions it is about to drop and constantly rising. Lanza, assistant director of international treasury operations at the Westinghouse Electric Corporation.

Many experts regard currency options as one potential solution to currency rate volatility, although there has been initial corporate resistance to their use.

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First, the term ''options'' can scare away more conservative corporate managers, who associate options with speculators. Waite Rawls, managing director of the capital markets group at the Chemical Bank. Also, currency options require that a premium be paid when the contract is entered into, whereas forward contracts generally involve a cash transaction only at maturity. Forward contracts, which are the obligation to buy or sell a currency, are traded on a very well-developed and efficient interbank market, not an exchange floor.

They have also been formalized as currency futures, which are traded in the pits of several international exchanges. Most corporate users say that the net result of the two is almost identical for hedging purposes. A currency option reduces risk to the premium paid, while still allowing the user to enjoy the benefit of favorable rate movements. The premium can run from about 1.

As enticing as currency options sound, there is still a lot of educating to be done before they become more accepted. But he needs to do more convincing first. Most experts agree that currency options are not likely to replace forward contracts completely. Their primary application is where the full extent of foreign currency payments or receipts is not certain or for longer- term contracts.

With the option you buy protection but are n't locked into buying or selling the currency. When the exposure is defined, we would go to a forward. The currency options market still shows signs of its relative youth, which is another factor keeping some potential users on the sidelines.

Companies can buy or sell options at the two exchanges where they are traded, or go directly to a bank. The Philadelphia Stock Exchange has been trading options in the Canadian dollar, pound, Swiss franc, West German mark and yen since The Chicago Mercantile Exchange trades just a mark option at present but expects to offer others this fall.

The Philadelphia exchange is enjoying the greatest activity. But most of the writing of currency options is being done by banks, which will customize the option, with maturity dates and sums beyond the standard exchange contract.

Many companies would also rather deal with a bank because they do not like the exchanges' margin requirements. Banks, in turn, have developed a nascent over-the-counter market where they trade options among themselves. They are also the largest players on the exchanges, where they hedge the risk they take when they sell an option to a customer. Some corporate treasurers, however, say that the banks' relative inexperience shows in a number of ways.

Saltmarsh of Apple said that when he shopped for options he found prices varied widely from bank to bank. Saltmarsh takes the lowest price at the banks, but will not deal with the exchanges because he cannot get a customized contract there.

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Also, many banks are said to be doing a poor job of hedging their risk. Prout of Continental Grain said. Nonetheless, many banks try to protect themselves with spot or forward contracts, which experts say amounts to trying to hit a constantly moving target with a fixed instrument.

Citibank leaves its currency options positions almost completely unhedged, according to Bruce Krasting, head of options trading. At the opposite extreme is Marine Midland. Dillman said that the bank was at least 50 percent hedged at all times. Aware of this weakness, banks are taking a more active role on the Philadelphia exchange to build expertise. Citibank, Marine Midland and the Bank of America are expected to take part soon in joint ventures with experienced traders as market specialists, said Arnold Staloff, director of new products on the exchange.

The developments are being greeted with optimism, even if many continue to call currency options an emerging product. But the benefits are regarded as so attractive that there is little doubt options will become a normal risk management tool within several years and perhaps sooner if the dollar remains volatile.

Prout of Continental Grain said, ''the company has a chance to have its cake and eat it, too. The American company exercises the option and purchases the necessary 2.

If the Yen Is Stable After three months the yen stays at yen per dollar.

The manufacturer allows the option to expire unexercised. If the Yen Falls After three months the yen falls to per dollar. Since the dollar buys more yen, the American company can now buy 2. The Americans buy the yen at the more advantageous rate in the spot market.

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CURRENCY OPTION GETS RESPECT By JAMES STERNGOLD Published: At Banks and Exchanges Companies can buy or sell options at the two exchanges where they are traded, or go directly to a bank. Relative Inexperience Seen Some corporate treasurers, however, say that the banks' relative inexperience shows in a number of ways.

Banks Expanding Role Aware of this weakness, banks are taking a more active role on the Philadelphia exchange to build expertise. Sweep to a Win Over the Heat.