Opportunities from Derivative Hedging Instruments in Volatile Foreign Exchange Markets

For some time now, the headlines of national and international newspapers have been filled with news of major fluctuations in the foreign exchange (FOREX) markets. The continued weakness of the Japanese yen and the rapid depreciation of the British pound have led some market participants to believe we are on the verge of a currency war.

In light of the surprising results of Italy's parliamentary elections and the automatic government spending cuts (sequester) in the U.S., it is safe to assume that the volatility in FOREX markets will remain high. Numerous Swiss companies that generate most of their revenues in foreign currencies while incurring most of their costs at home are seriously affected by this development: Within a matter of weeks, fluctuating exchange rates can irrevocably wipe out their hard-won competitive advantages!

One possible solution to this problem is active currency management that takes into account the individual situation of a company. This approach, however, cannot be seen as a magic formula for every eventuality. In addition to choosing the proper exchange rate hedging instrument, this solution also takes into account the current competitive situation, demand elasticity, and predictability of payment flows. This list of points to be considered is in no way exhaustive. Analysis of additional factors is indispensable for professionally determining the scope of risk management.

If the payment flows can be predicted with sufficient accuracy but without the possibility of adjusting prices or negotiating currency terms, then they can be hedged using traditional foreign-exchange forwards or currency options. This requires the company's management to decide in advance what percentage of the budgeted revenues should be hedged and what currency hedging instruments should be considered. Once a strategy for controlling foreign exchange risk has been chosen and implemented, it should be aligned with the rate used for annual costing rather than fundamentally changed every year to meet current market expectations. This provides management with an effective means of ensuring that currency fluctuations do not eat up the margin earned from business operations.

As a practical example, let us examine an exporter based in the euro zone with production costs in Swiss francs. Its strategy calls for 80 percent of budgeted income to be hedged for the entire year. First and foremost, this situation lends itself to traditional foreign-exchange forwards. Although this instrument eliminates the risk from negative exchange rate developments and creates a secure basis for costing, the exporter forgoes any opportunity to take advantage of renewed appreciation in the exchange rate. To avoid this dilemma, it would be worthwhile for the exporter to examine put options or structured hedging transactions such as risk reversals or knock-in forwards.

In a put option, the purchaser acquires the right to sell a predetermined amount in euros at a pre-set rate on a certain maturity date. Use of this exchange rate hedging instrument enables the company to take unlimited advantage of a rise in the European single currency while still protecting itself against falling exchange rates. However, acquiring this right might entail considerable premium costs, which is why decision-makers should also take a closer look at structured hedging transactions. In a structured hedging transaction, the user acquires the right to sell its excess foreign currency, financing it not from liquid assets but by incurring obligations for the same amount. One very simple example of this form of hedging strategy is risk reversal. This strategy involves calculating distinct maximum and minimum rates to be used on the maturity date depending on the scenario. This creates a clear basis for costing with no additional premium costs, enabling the company to continue leveraging slight upward movements in the underlying exchange rate. In addition to risk reversals, knock-in forwards can help establish minimum limits that allow the company to profit from exchange rate appreciation up to the predetermined barrier.

The common denominator of all these instruments is that they can protect the companies involved from unwanted effects of exchange rate fluctuations. As the examples above demonstrate, these hedging transactions can be configured in many different ways and tailored to individual needs. Thus, they enable efficient control of exchange rate risk.

For more information about our offering for corporates, please see the following website:

Stephan Ulrich, Senior FX Sales, Corporate & Private Clients, Credit Suisse AG, Zurich

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