In the past, many treasurers would have automatically opted for the latter, where cash flows were certain – or at least highly probable – but there are a number of scenarios in which this assumption can be flawed.
Firstly, the corporate’s business may be correlated to the foreign currency being hedged, which is typically the case in emerging markets. If a company selling goods in Russia and hedging expected sales in RUB hit trouble, sales volumes would fall and the company could find itself over-hedged.
The hedging of an acquisition is not straightforward either. Even after shareholders agree to a deal, there may be regulatory approvals to obtain, which means a UK-based corporate paying for the acquired company in USD would be exposed to the risk of the dollar appreciating.
“In this scenario, hedging with a forward would be risky as the timing of the transaction is uncertain,” says Romain Camus, head of exotic options at Digital Vega.
“If the regulators did not approve the transaction, the company would be left with a forward without having the underlying economic exposure and could be exposed to significant losses.”
Digitalization of options flow has provided transparency and this is certainly contributing to the increase in volumes
– Romain Camus, Digital Vega
Another situation in which an option is a better product for hedging FX risk is when a company is involved in a large tender process where it has to provide a quote, but is uncertain about whether it will win the tender.
Costs and margin can be protected by entering into FX options without the obligation of settling any FX transaction if the tender is lost.
Even if a corporate hedges a currency exposure that is certain, a forward may not be the most appropriate instrument. The hedging rate may not be attractive, for example if a corporate hedges foreign revenues in a currency that is close to historic lows.
A further factor working in favour of options is reduced volatility among the major currencies. This trend is reflected in the JPMorgan volatility index, which tracks the currencies of the G7 economies and touched its lowest level since 1992 earlier this year.
“Lower volatility implies lower options premiums, which are beneficial for buyers,” says Paul Houston, executive director and global head of FX at CME Group.
“However, corporates need to be aware that the spreads of buying and selling options tend to remain constant and are therefore proportionally larger at lower volatility.”
Fortunately, there are mechanisms treasurers can use to reduce the cost of the premium charged when purchasing an option to cover the transfer of risk, for example selling options to net off against the options they are buying.
Options can thereby be combined to create a variety of risk/reward profiles to suit specific exposures, whereas forwards tend to fix the hedge rate to a specific date and create a linear risk/reward strategy with little flexibility.
Corporates looking to lower their options costs could also set a strike rate that is far away from the current market rate and would typically be the worst possible rate the company was comfortable with, says David Moya, a senior manager at treasury management consultancy Zanders who focuses on corporate clients.
The strike rate is the price at which the holder of an option can buy or sell the underlying security when the option is exercised.
“Selling another option to offset – totally or partially – the premium cost would give protection to the company on the downside while allowing it to participate in the upside potential until the strike rate of the written option,” he says.
“However, this strategy would not be advisable in situations where cash flows are uncertain.”
The extent to which corporates are prepared to add optionality into their hedging programmes usually comes down to the same factors, suggests Pritesh Ruparel, head of options at Sucden Financial.
“These considerations include the level of comfort a treasurer has with trading options; the systems architecture of the treasury desk to help them manage and assess the hedging programme; and the availability of good data so that they can assess pricing from their liquidity providers,” he says.
Options are more complex to understand, risk-manage, track and account for than forwards, but corporates are becoming more knowledgeable and comfortable with them, adds Camus at Digital Vega.
“Digitalization of options flow has provided transparency and this is certainly contributing to the increase in volumes,” he concludes.