Forward exchange contracts provide a means of hedging straightforward risks that are certain in nature such as settlement risks linked to payables and receivables. Options, which give the buyer the right – not the obligation – to exchange one currency against the other at a certain rate in the future offer a greater diversity of risk-reward profiles for companies looking to offset complex risks. The option products available range from barrier options to average rate options, double average options and basket options – all of which can play a key role in a corporate’s hedging strategy. Accounting standards, however, only allow limited hedge accounting treatment for options.
Options are a complement to orwards when hedging cashflow volatility. If uncertainty regarding future cashflows is high, a greater proportion of the risk should be hedged using options. Options are also ideal for hedging contingent exposures such as mergers and acquisitions. Debt can provide the best means of offsetting net investment risk, although low premium options are also appropriate. Companies are becoming increasingly concerned about year-on-year FX-induced volatility in their earnings. Double average forwards or options are suitable for hedging earnings translation risk.
