Show all articles in this section

The beauty of options

AUTHOR: Professor Chris Adam   DATE: 30.08.04   ISSUE 2, 2004

An Australian Industry Group report (January 2004) has found that Australian manufacturers have been severely hurt by the increased volatility of the Australian dollar.

From a survey of 800 manufacturers conducted by the AIG in late 2003, a majority of respondents felt the market value of their companies had been adversely affected by the then appreciating dollar. Some 20 per cent took the view that a continuation of this change in currency value would be enough to drive them to shift some of their production offshore.

This is a clear example of a section of business that is unhappy with, and has failed to find an effective way to manage its exposure to, numerically bigger movements in our currency.

It is now common for the Australian dollar to move as much as one cent a day, which is a much bigger threshold than we were dealing with less than a decade ago. If the daily movement had been that big in the mid-1990s it would have been a signal for substantial concern. Now we have learnt to live with this new threshold and volatility.

The foreign exchange risk management problem for many businesses is that while they have learnt to live with more volatility, they may not be managing their exposures to that volatility with the best hedging instruments available.

Our manufacturers are typical of many businesses that are asymmetric in their response to currency movements. This means their businesses generally will be hurt by volatility only in one direction.
For example, a manufacturer that exports a substantial proportion of its output, produced mostly from local products and labour, will benefit from a depreciation of the Australian dollar but will suffer from an appreciation.

{

Only a company that is totally balanced in its transactions with each foreign currency will appear to be indifferent to exchange rate movements.

}

ILLUSTRATION: Gregory Baldwin

If the Australian dollar depreciates it reduces the manufacturer’s price (in foreign currency terms) and increases the Australian dollar value of foreign revenue received. An appreciation of the Australian dollar reverses these benefits, reducing Australian dollar revenues for the manufacturer. On the other hand, a company that is primarily an importer tends to prefer an Australian dollar appreciation and dislikes depreciation.

Only a company that is totally balanced in its transactions with each foreign currency will appear to be indifferent to exchange rate movements. A company that exports and imports in the same foreign currency for about the same amount will not care what happens to the exchange rate because its gains and losses from exchange rate changes are offset. This is an example of a natural hedge.

Even here, however, an apparent lack of exposure may be an illusion: although the company itself may be insulated, its competitors may not be similarly protected. Hence, exchange rate changes can affect a company’s strategic position by affecting its competitors.

The markets are also asymmetric in that we mostly see bigger currency falls than rises. For these reasons, it follows that businesses ought to consider using instruments to better match this asymmetry, such as options, in combination with or instead of symmetric instruments, such as forward contracts and swaps.

A classic example where it did not pay to use forward cover to manage foreign exchange risk is a case involving the Australian cotton industry in 2002. Australian cotton producers that exported had forward foreign exchange cover at a fixed US-dollar price. (Interestingly, few had taken forward or futures cover on the US dollar cotton price itself, although this was available.) When the US dollar appreciated, the cotton producers saw an opportunity loss and illegally abandoned their contracts in order to profit from the rise in value of the US dollar.

If the cotton producers had used options to hedge against the downside risk on their US dollar-denominated contracts, they could have legally abandoned those options when the US dollar appreciated and gone to the spot market to collect the upside gain. That’s the beauty of options: you are not locked in.

Why not options?
We know that about 70 per cent of businesses in Australia use some form of hedging against foreign exchange risk, but options have not been taken up much.

In global financial markets the trading of currency options has been thin, despite the contribution of the path-breaking Black-Scholes option pricing formula and related formulae that have given us the capability to price derivative securities more accurately. For example, the largest foreign exchange market in currency options is Philadelphia in the US, but this is small compared to markets in Chicago and New York, which trade spot and futures contracts on currencies.

I have little doubt that the technical complexity of options has dissuaded people from using them more. Options can be used to buy a currency or other financial asset at a future date at a price agreed now (the exercise price), or to sell an asset, just like forward and futures contracts. An option to buy is a ‘call’ option, and to sell is a ‘put’ option. Unlike currency forward contracts (where pricing is relatively simple in that it is based on the interest differential between two currencies, generally costing from 1/2 to 11/2 per cent of the contract value), currency options pricing is governed by six factors. These are the strike or exercise price at which you contract to buy or sell the underlying asset on which the option is written; the current (spot) price of the underlying asset; the risk-free interest rate; the time to maturity to exercise the option; the volatility of the underlying asset price; and the forward price of the currency.

The beauty of options is that you do not have to exercise or deliver on them at the maturity date. With forward contracts, you would still have to deliver on this contract and could not cheaply abandon it.
Many different formulae exist to set the premium of an option, but all respond to changes in the six key variables in the same direction. For example, if the volatility of the underlying currency increases, the value of a call option increases because it is more likely that you will want to exercise the option at maturity, since it is more likely it will be in the money. This is why it is difficult, in general, to compare the direct observable cost of an option with alternative hedging instruments such as forward or futures contracts.

If a company holds forward contracts it must deliver on them even if the exchange rate at the maturity date makes it more attractive to use the spot market to convert the foreign exchange.

Because options give companies the choice of using the contracted price (exercise price) or abandoning it to use the spot price, they may be more valuable than forwards. They can reduce the costs of currency hedging by allowing opportunistic profits to be made when the contracts fall due.

Given the asymmetric impacts of exchange rate changes on many companies, it may be that the relative gains from using options for foreign exchange management could outweigh the seemingly lower costs of forwards.

Understand and measure your exposure
However, it is important to remember that no matter what combination of hedging instruments are available or used, dynamic hedging strategies first require businesses to understand their exposure.
Businesses should know how sensitive they are to unexpected changes in their value resulting from exchange rate adjustments or other factors such as interest rates. They should think about the impact of foreign exchange rates on imported goods and services, and remember that when measuring their total exposure and net position, factors such as interest rates and commodity prices can cancel one another out.

To measure the impact of exchange rate changes on current and future activities, it is a good idea to unbundle cash flows with foreign exchange components by type of cash flow, and to consider cash flows that may occur in the future. Businesses also need to understand what proportion of the business is exposed. For example, the impact of a large exchange rate variation of 20 per cent will be low if it only applies to 1 per cent of the business.

In a world of increasing currency movement volatility, currency risk management is undoubtedly an important strategic tool for safeguarding earnings.

My prediction is that the established asymmetry of volatilities in the world’s currency movements, and the asymmetric impacts of exchange rate movements on corporate valuations, will see the emergence of more instruments like currency options to manage risk in a more targeted, one-sided manner, for lower overall cost to corporations.