Question

This is on hedging and speculation.

1. If you have a foreign amount receivable, how would you hedge with options? What is the intuition behind this approach?

2. If you have a foreign amount payable, how would you hedge with options? What is the intuition behind this approach?

3. How would you hedge foreign receivables/payables with a forward contract?

4. What is the difference between hedging and speculation? In other words, what is the goal of hedging versus speculating?

Answer 1

There are two kinds of risk here - currency risk and receivable risk.

Foreign exchange risk can arise either due to transaction exposure (i.e., due to receivables expected or payments due in foreign currency). Investors can hedge against foreign currency risk by purchasing a currency put.

Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.

Accounts Receivable Put Options is a product that can offer your company protection on 100% of each invoice amount in the event that your customer, a publicly traded company, declares bankruptcy a credit risk management tool that can address the ever-increasing concern that vendors have about their customers’ credit quality and financial stability.

The main advantage of using options contracts for hedging is that the hedger can decide whether to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the downside risk while retaining the upside potential.