Hedging your risks with a currency option

You can take out a currency option if you want to be sure of a minimum exchange rate in the future. Or if you have issued a quotation in a foreign currency.

A currency option gives you the right to exchange a foreign currency at a certain rate. If the exchange rate at the point of payment has turned strongly to your advantage, then you do not need to use the option. So a currency option hedges your risk, but you still benefit if the exchange rate turns out favourably. You pay a premium for this right.

Pro's

  • Confidence on the exchange rate.
  • You are insured against negative FX-rate fluctuations.
  • You still benefit from favourable price developments

Cons

  • You pay a premium.

How does it work?

To hedge your risks, you pay a premium in advance. This gives you the right to an agreed minimum exchange rate in the future. And if the exchange rate turns out favourably? Then you can buy or sell the foreign currency at the more favourable level.

There are two types of currency option, which you use depending on whether you expect a higher or lower exchange rate:

  • Call option: You buy the right to buy a certain currency at a fixed price. You use this when you expect the exchange rate to rise.
  • Put option: You pay for the right to sell a certain currency at a fixed price. You buy a put option if you expect the exchange rate to fall.

Example

In three months times, you have to pay an amount in dollars to your supplier in the US. You want to protect yourself against a rise in the relative value of the dollar, but also benefit from a potential fall in the dollar price. So you buy a call option on the dollar. That gives you the right in three months time to buy dollars at € 0.85.

There are two possible situations on the agreed date:

  1. The actual price of the dollar is higher than € 0.85. You exercise your option right. This means you buy in dollars cheaper.
  2. The dollar price is lower than € 0.85. You do not use your option right. You now buy dollars cheaper than the actual price.