Hedging Currency Exposure: Options vs Forward Contracts

This article discusses the use of options and forward contracts to hedge currency exposure. It provides a case study of a company that needs to purchase $7.5 million US dollars and has revenues in Canadian dollars. The article explains how to use options and forward contracts in three different scenarios where the exchange rate between the Canadian dollar and US dollar varies. It also highlights the advantages and disadvantages of each method.

INTERNATIONAL FINANACE

1. Cain is concerned about the current exchange rate fluctuations because it has to make
payment of US$7.5 million at the end of January. Its revenues accrue in Canadian
dollars, C$. If the Canadian dollar depreciates against the US dollar then Cain’s
company will have to pay more in Canadian dollars to buy $7.5 million US dollars.
This will have an adverse impact on its profitability.
Cain’ s position is long on US dollars and short on Canadian dollars , with regard to the $7.5
million US dollars that it needs to purchase by the end of January to make its payment.
2. If Cain decides to use options then she would use call option on US dollars. This call
option would give her the right to purchase US dollars at a fixed price in terms of Canadian
dollars at a future date. This future date in this case will be the end of January when her company
Pixonix has to make the payment. If at the end of January, the call option is in-the-money, it will
be exercised, else not.
3.1. US $ = CAD $
In this case the forward contract will have to be exercised. It is November 2 now. 3
month forward rate for a long position in US dollars is .934160 US dollar / Canadian dollar. So $
7.5 million US dollars will be bought by paying 8.028 (7.5/.934160) Canadian dollars. If the
hedging had not been done and the position was unhedged then Pixonix had to just pay 7.5
million Canadian dollars to buy 7.5 million US dollars because exchange rate at the end of
January would be 1 US$ = 1 C$.
In case the option strategy is used then the call option with strike price closest to the spot
price on November 2 would be chosen. The spot price on November 2 is US $1.0717/ C$. So
call option will be bought on 17/08 JA contract that has an exercise price of $.95/ C$. At the end

of January when the spot price is 1 US$ = 1C$, this option will not be exercised. It will be
allowed to expire. The price of this option per US $ is 2.60%. The total premium that the
company will have to pay for buying on $7.5 million is 195000 C$ (7.5 million * 2.6%). The
company will lose this much amount in comparison to the un-hedged position because the call
option being out of the money at the end of January. If the hedging had not been done and the
position was unhedged then Pixonix had to just pay 7.5 million Canadian dollars to buy 7.5
million US dollars because exchange rate at the end of January would be 1 US$ = 1 C$.
2. US $ =C $.09
Pixonix will purchase $ 7.5 million US dollars through the forward contract by paying
8.028 Canadian dollars. If the position was unhedged then to purchase US $ 7.5 million, it should
have paid just $675000.
The call option would not be exercised since it will be deeply out of the money. It will be
cheaper to buy US $ at the spot rate of 1 US$ = C $.09 than to exercise the option. Loss due to
hedging will be the premium paid of C$ 195000 for buying the call option.
3. US $ = $1.10 CAD
Cain or Pixonix will purchase $ 7.5 million US dollars will be bought by paying 8.028
million Canadian dollars ($7.5/. If the position was unhedged then to purchase US $ 7.5 million,
it should have paid 8.25 million Canadian dollars. The hedged position would result in savings of
.222 million Canadian dollars.
The call option will be in the money in this case. It will be exercised to purchase US
dollar at the exercise price of .95/ C$. So to purchase US$ 7.5 million, 7.89 million C$ will have

to be paid. This will be less than the 8.25 million C$ that will have to be paid in case of un-
hedged position.
4. The forward prices for three months show that the market expects the US $ to
appreciate against the Canadian dollar. The volatility in the exchange rate movement between C$
- US$ also calls for the need for Pixonix to hedge its currency exposure. Therefore Cain should
hedge her position in US dollars.
She should use call option on 17/08 JA option for this hedging. This option has a strike
price of US $.95/ C$. Cain will have to pay option premium of $195000 for buying this long call
option. At the end of January, if the option is in the money, then it would be exercised. However
if it is out-of-the-money and it is cheaper to buy US$ in the spot market then this option will not
be exercised. It will be allowed to expire. The advantage of using options over forward is that
Cain will not get bound by the forward contract. Forward contracts are contracts that have to be
fulfilled. Options are just rights which are to be claimed only if the option is in-the-money.