Currency hedging – to option, or not to option?
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Since September 2008, importers and exporters have been experiencing a roller coaster ride on global currency markets. In past issues of Educational Research, we have discussed the role of direct and indirect currency risks. Indirect risks are those difficult-to-identify and unpredictable risk components that arise when shifts in currency relationships impact the amount represented by orders and sales.
This occurs, for instance, when a German producer issues invoices in euro, while the customer in Poland experiences an increase in import prices as a result of weakness in his domestic currency, the zloty, and therefore pushes for renegotiation of the delivery terms. In May 2009, we began a multi-month study, with the support of university researchers, to answer the following three questions:
- When does it make economic sense to hedge using currency options?
- Which hedging approach is most suitable for small to medium-sized companies?
- In the case of more than 6 currencies within a company – what is the role of correlation in setting hedging policy?
The job of the sals.a team is to describe the baseline situation. The Department of Mathematical Finance at our partner university will then carry out the methodological and statistical analysis. This includes both back testing and simulation methods. The results will be published jointly here in Educational Research, with practical examples made available by sals.a.
Description of the status quo: The high volatility of forex markets makes option premiums relatively expensive. Does the higher premium compensate for the observed fluctuations in currency exchange rates? Two alternatives will be examined:
- Ongoing, order-specific hedging (monthly) – green line
- General price hedging – one price for monthly exchange transactions over a one-year term (01 Jan – 31 Dec) – red line
Order-specific vs. general price hedging with options
Order-specific vs. general price hedging with forwards
| Average exchange rates under the different hedging strategies 2006 - 2008 | 2006 | 2007 | 2008 |
|---|---|---|---|
| No action | 1.2512 | 1.3651 | 1.4543 |
| Strategy 1 Option – order-specific | 1.2475 | 1.3602 | 1.4619 |
| Strategy 2 Option – general price hedge | 1.2323 | 1.3508 | 1.4598 |
| Strategy 1 Forward – order-specific | 1.2426 | 1.3546 | 1.4689 |
| Strategy 2 Forward – general price hedge | 1.2090 | 1.3344 | 1.4718 |
| Nominal | 1 000 000 |
|---|---|
| Position | Receive USD |
| Trading day | 10 Dec 2007 |
| Initial Exchange | 10 Jan 2008 |
| Final Exchange | 10 Dec 2008 |
| Exchange Frequency | monthly |
| Date | Volume |
Analysis shows that a general price hedging strategy based on forward contacts is the better solution in years of limited volatility. In more volatile times, longer option strategies do better relative to conventional forwards.