Businesses that trade in foreign currencies are at risk of losing money because of changes in the exchange rate.
Incoming or outgoing payments made in foreign currencies are at risk when there is a delay between a payment being agreed to and it being made. If exchange rates change unfavourably in this time, the company will either receive less or have to pay out more than it planned.
For example, a British manufacturer of clothing may take an order from the EU for €10,000 worth of clothing. They may agree to the order on a certain date and send the goods to the buyer shortly after. At the time of sale, the exchange rate may be 0.85 EUR/GBP. As such, the manufacturer will be expected to convert the €10,000 that they receive into £8,500. However, there may be a time gap between the company making the sale and actually receiving the payment. In the intervening period, the exchange rate could change, making the euro worthless. When the company receives their payment in euros it might convert to, say, only £8,000. The company will have earned £500 less than they expected because exchange rates have changed.
This is where FX hedging comes in. FX hedging just refers to the process of doing something to prevent this from happening.
Many companies hedge FX transactions they are expecting to make by going to a third party to make a deal. Traditionally this has either been a bank or a broker, although Bound provide the same services without being a bank or broker. This third party provides a contractual agreement that the company can use to ensure that they receive a certain exchange rate when they agree to make or receive payments in foreign currencies at future dates.
One of the contractual agreements that a company can make is called an option trade and this article will explain how option trades work.
How Option Trades Work
With an option trade, a company that trades in foreign currencies will have the option of exchanging currencies at a fixed rate on a future date if it wishes to do so. This fixed rate will be a rate at which the company is happy to exchange money.
A key point with option trades is that the company which takes out an option trade has the option of whether they actually use it or not.
Most importantly, a company will be insured against unfavourable exchange rate changes because they have the option of exchanging currency under the option trade agreement. However, they can also benefit if exchange rates change favourably. If exchange rates change favourably, they can opt-out of the option trade and exchange currency at the market rate.
Often option trades are used when a business is unsure about whether or not it will make or receive a payment in a foreign currency. However, they can also be taken out by businesses that have already agreed to either buy or sell in a foreign currency.
Going back to the example will help to explain how option trades work.
Back to the Example
If our UK-based clothing manufacturer was expecting to receive an order for €10,000 worth of clothing from an EU buyer, they may wish to take out an option trade.
Before the buyer actually places the expected order, the manufacturer could approach a third party (either a bank, a broker or Bound) to set up an option trade. With an option trade, the third party would agree to exchange euros into British pounds at a set rate on a future date. For example, they may agree to exchange euros for pounds at a rate of 0.85 EUR/GBP after three months.
What this means is that if the manufacturer does then receive an order for €10,000 worth of clothing from the EU buyer, they are guaranteed to at least be able to exchange the euro payment back into pounds at a rate of 0.85 EUR/GBP. If there is a delay in them receiving payment and exchange rates change unfavourably, their exchange rate is protected by the option trade that they have taken out. If the payment is received, say, three months later, they take the euros to the option trade provider who exchanges them back into pounds at 0.85 EUR/GBP. The company receive £8,500 as expected, even if normal exchange rates have changed unfavourably. As a result, they will not have been affected by the change in exchange rates.
If the expected deal does not take place, the company can back out of the option trade. On top of this, if exchange rates move favourably, the company can back out of the option trade and trade at normal exchange rates. In this situation, they will benefit from the favourable exchange rate change.
In our example situation, there are three possible outcomes with an option trade.
Outcome #1 - Exchange Rates Moves Unfavourably
As we’ve just gone through if the company takes out an option trade and then they receive an order from the buyer based in the EU they will be insured against currency loss. If the sale is agreed and then payment is received three months later and the euro has weakened against the pound, the company can use the option trade to convert euros back into pounds at the rate agreed in the option trade.
This rate is better than the current normal exchange rate (also known as the ‘spot’ exchange rate) and the company is unaffected by the change in exchange rates.
Outcome #2 - Exchange Rates Moves Favourably
The example manufacturer may take out an option trade, receive the order and then receive payment at a later date. At this later date exchange rates have moved in a favourable direction. The euro may have strengthened against the pound. By converting their euro payment at current market rates it will be worth more in pounds than what they would get if they converted it through the option trade.
In this case, they opt out of the option trade and take a spot trade instead. This means that they just exchange currencies at the current exchange rate. What they receive in pounds is higher than they expected.
Outcome #3 - The Expected Transaction Does Not Occur
If the company takes out an option trade but the expected deal does not take place, then they can just opt out of the option trade. As we’ll explain later, while they will lose the fee they paid for the option trade, this is better than with a forward trade. This is because there is an obligation to exchange currencies once a forward trade has been agreed to.
The Option Trade Fee
One issue which slightly complicates option trades is that there is a fee for taking one out. If the exchange agreed to in the option trade is not executed, the fee is lost.
As well as meaning that money is lost where no deal takes place, this slightly complicates the issue of opting out of an option trade and taking a spot trade when exchange rates change favourably. This is because to opt-out of an option trade and takes a spot trade instead, exchange rates have to move far enough for the loss of the fee to be negated as well.
Can Option Trades be Used if a Deal has been Agreed To?
Yes, option trades are not only used by companies that are just expecting to deal in a foreign currency. They can also be used by companies that have already agreed to buy or sell in a foreign currency.
Can Importers Use Option Trades as Well?
Option trades are just as applicable to importers as they are to exporters. The same thing just happens in reverse.
Going back to our example, if the company was importing clothing from the EU instead of exporting it, they could take out an option trade for a purchase they were expecting to make in euros. The option trade would protect them if exchange rates caused the pound to weaken against the euro. Without an option trade, a weakening of the pound would make the purchase cost more. Alternatively, if the euro weakened against the pound, they would be able to disregard the option trade and take a beneficial spot trade instead. This would allow them to make the purchase more cheaply than anticipated.
How Option Trades Compare to Forward Trades
In simple terms, forward trades are the same as option trades except that you do not have the option of opting out.
With a forward trade, the bank or broker (or Bound) who provide the forward trade agree to exchange an amount of currency at a set rate at a future date. This agreement protects a business from exchange rate changes when they agree to make a transaction at a future date. The key difference is that with a forward trade a company that takes one out cannot opt-out if either the expected transaction does not occur or if they would like to take advantage of a favourable change in exchange rates.
Option Trades in Summary
Option trades are one of the most flexible FX hedging strategies available to businesses that either buy or sell in foreign currencies. While they may be complicated at first, getting to grips with how they work isn’t too difficult.
With an option trade, a company can insure itself against currency loss and take advantage of favourable changes in exchange rates. While they come at a cost, this cost is relative to the risk that a company takes when trading in foreign currencies anyway. With an option trade, a company can at least make sure that they will either protect their profits or avoid unexpected costs which arise as a result of exchange rate changes. On top of this, they also leave the option of profiting further or making extra savings when exchange rates move in a favourable direction.