Treasury Departments Owe Their Livelihoods to Forex Options for Hedging
Courtesy of Tom Cleveland, currency analyst for Forex Traders
Foreign currency traders often forget that their chosen medium is actually there to facilitate cross-border commerce, not to provide a speculative playground for day, swing, and position forex traders. The "numbers", however, seem to tell a different story. According to the Bank for International Settlements, over $4 trillion is traded daily in our currency markets. Global commerce, necessary capital flows, and hedging activities only account for 20% of that volume, leaving 80% for active managers, hedge funds, and major global banks to transact for speculation.
Within this abundance of speculative activity, treasury departments within major corporations with international "footprints" must mitigate their respective company's foreign exchange rate risk. A recent study indicates that over 94% of the entities contained in our S&P 500 index use option contracts or related derivatives to hedge their various exposures, ranging from forex at the 94% figure, down to 88% for interest rate risk and 51% for commodity price swings. Another study reveals that treasury analysts have doubled their use of options in the past year to deal with the volatility in our financial markets brought on by the European debt crisis.
One can find the authorization for the use of various options contracts within what is commonly referred to as the "Treasury Policy", a document typically approved at the highest level that dictates when, how, and what can be used to mitigate foreign exchange risk. Corporate financial statements must also contain a standard disclosure that summarizes the entity's risk exposure and what instruments are outstanding at a specific point in time. The policy generally precludes any speculation, but requires that any material risk exposure be measured and mitigated.
Evolution has been kind to treasury analysts. Many beginners, when confronted for the first time with a future cross-border payment commitment or revenue possibility, called their friendly banker and purchased a currency forward, thereby locking in today's exchange rate. If the payment details changed or the currency markets were favorable, the budding analyst had to switch gears or, in the latter case, get yelled at by his superiors. Global banks could provide "customized" options, but these were limited to clients of the bank that might require the opposite side of the transaction. As standard option agreements grew and prospered, they became the "weapon of choice" for hedging currency risk.
Options are like insurance in a way. You have an uncertain risk that is defined enough to allow for protection at a reasonable price or premium. If currency markets move against your position, you exercise the option to cover your loss, less the premium. If currency movements are favorable, then you allow your option to expire and transact your business at the better rate. Option contracts protect your down side while allowing you to participate in the upside potential of the market, the very reason that options are preferred in this arena.
Treasury analysts have also taken this "simplified" example to much higher levels of complexity by adding numerous option "layers" to the original transaction. Software vendors have been quick to develop automated routines for tracking the multitude of transactions that are inter-related. Imagine what could happen if a key employee resigned or was terminated. Who would know the what, how, and when for actions that must be taken?
Forex hedging with options can get complex in a hurry. If you are an individual investor with overseas investments in your portfolio, you may be at risk if the U.S. Dollar appreciates in 2012. Many experts expect a 10% upward move. Consult a professional before you embark on any personal hedging strategy.
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Courtesy of Tom Cleveland, currency analyst for Forex Traders