Hedging currency risks

Currency hedging is one of the most sought-after financial products among companies that have experienced losses due to currency risk and recognized the need to manage it. AME Capitals offers a wide range of financial instruments and solutions designed to effectively manage risk in a volatile exchange rate environment.

Instruments

There are two basic hedging instruments: currency forward and currency option. Understanding how the basic instruments function allows you to combine them with different parameters with each other to get the required result.

Currency forward

A currency forward is a simple and most common hedging instrument that allows you to fix a rate for buying or selling a currency at a future date. There are two types of currency forward:

A deliverable currency forward: an agreement between the parties to buy/sell a certain volume of currency at a fixed (forward) rate at a certain future date.

A non-deliverable currency forward differs from a deliverable currency forward in that at the end of the term the parties do not exchange payments in different currencies, but one of the parties pays the other party the difference between the prevailing exchange rate and the forward rate, the direction of payment being determined by the sign of the difference.

The buyer of the forward (currency buyer) makes a profit if the exchange rate on the settlement date is higher than the forward rate and a loss if the exchange rate on the settlement date is lower than the forward rate.

Example 1. The current exchange rate of the US dollar to the Pound is 1.65. An importer purchases goods from a supplier for currency and enters into a contract to sell at a price in U.S. Dollars with payment due in one month. The Company enters into a one-month forward with a broker to purchase currency at a rate of 1.655. After a month, the rate is 1.68.

Deliverable forward: the company buys currency at the rate of 1.655.

Non-deliverable forward: the company receives a payment of $0.25. per 1 lb. and converts the currency at the current exchange rate of 1.68, resulting in an effective exchange rate of 1.68-0.25=1.655.

Entering into a forward contract implies an obligation for the company to buy or sell currency at a fixed rate (for a deliverable forward), or to receive or pay the exchange rate difference (for a non-deliverable forward) regardless of the exchange rate at maturity of the forward. As a result, even in the event of a favorable change in the exchange rate in the normal course of business, the obligations under the concluded forward contract are still subject to fulfillment on the previously agreed terms. AME Capitals requires the posting of cash collateral to secure the other party's performance of its obligations.

Currency option

The principle of action of a currency option for its buyer is similar to insurance against an unfavorable change in the exchange rate, while in case of a favorable change in the exchange rate the buyer of the option is free from any obligations. Unlike a currency forward, a currency option has a value (premium) that the buyer of the option pays to the seller upon purchase.

There are two types of currency options: an option to buy a currency (call option) and an option to sell a currency (put option).

A call option is a contract that gives the buyer of a call option the right to buy a certain amount of currency at a fixed rate from the seller of the call option at a certain future date. The buyer of a call option may not exercise this right if the exchange rate has changed favorably.

Similar to deliverable and non-deliverable currency forwards, there are deliverable and non-deliverable currency options. The latter are not settled by the purchase/sale of currency, but are replaced by the payment of a compensating difference.

Option combinations

By combining basic instruments with different parameters with each other it is possible to achieve the required payout profile.