Question

1. A U.S. company needs to pay Japanese Yen for the equipment purchase in the next six months and would like to hedge its foreign exchange rate risk. Please construct a range forward strategy using foreign currency options.
2. How should this U.S. company hedge by using the standard forward contract? How would you compare the hedge using the range forward strategy with the hedge using the standard forward contracts?

Answer 1

When companies have known amount of foreign currency payable or receivable, the home currency equivalent of which is uncertain, there arise a transaction exposure. So to hedge against the currency exchange risk companies adopt various techniques. Some of the techniques are:-

1. Construct a range forward strategy using foreign currency options.

1. Hedge using the standard forward contracts.

              A range forward contract is a zero-cost forward contract that creates a range of exercise prices through two derivative market positions. A range forward contract is constructed so that it provides protection against adverse exchange rate movements. In a range forward contract, a trader must take a long and short position through two derivative contracts. The combination of costs from the two positions typically nets to zero. Large corporations often use range forward contracts to manage currency risks from international clients.     

      A company may use foreign currency options to hedge against currency risks. They can either have 4 positions under "call" & "put" options to cover currency risks as follows :-

1. C+ ie , right to buy (bullish)
2. C- ie, obligation to sell (bearish)
3. P+ ie, right to sell (bearish)
4. P- ie, obligation to buy (bullish)

The company has to pay premium for buying these options and take another position also. Costs from the two positions typically nets to zero.

Since in the given case US company has Japanese yen payable, is bullish on yen so, it can either take position in :-

1. Right to buy & an obligation to sell

                             or

1. Right to sell & an obligation to buy

A standard forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments.

In the given case company has foreign currency payable (yen) is under obligation to pay yen after six months. So the company can buy a forward contract to hedge against the currency exchange risk.

                                                                   DIFFERENCES

Range forward strategy using foreign currency options.

foreign currency options allow businesses to buy or sell a set amount of currency at a specified exchange rate. However, currency options offer more flexibility for making exchanges.

Basic options, known as “plain vanilla” options, are the simplest and most common type of option.1they are always conducted in “put and call pairs,” meaning each transaction entails a sale (“put”) and a purchase (“call”). Notably, options give businesses the opportunity, not obligation, to “strike” at the agreed upon exchange rate on or before the established expiry date, depending on the style of option.

American-style options, for example, can be exercised before the expiry date, while European-style options can be exercised only on the expiry date. American-style options can create more opportunities for businesses to benefit from favorable FX movements, but they often come at a higher premium

standard forward contracts.

One of the most straightforward currency-hedging methods is the forward contract, a private, binding agreement between two parties to exchange currencies at a predetermined rate and on a set date up to 12 months in the future. In other words, the parties agree upon an exchange rate to hedge against currency fluctuations and increase their financial certainty.

Notably, they are non-standardized and unregulated, hence their private nature. As such, they are traded “over the counter” (OTC) between two parties, rather than through a public derivatives exchange. Because they are not standardized, forward contracts can be customized to each party’s needs. However, forward contracts cannot be traded in a secondary market, and each party is committed to the currency exchange on the contract’s expiry date.

Various types of forward contracts include window forwards, which allow the exchange to take place at any point between two set dates, long-dated forwards (for more than a year up to 10 years) and non-deliverable forwards (in which the difference in value between the two currencies is delivered, rather than the currency itself).