Series 7: 5.5.2.1. Hedging Foreign Exchange Risk

5.5.2.1. Hedging Foreign Exchange Risk

Exporters buy puts to hedge their currency risk. Selling internationally means being exposed to fluctuating foreign currency markets; in particular, when an exporter commits to deliver product before receiving payment. Since currencies are so volatile, by the time payment is received, the value of the currency may have dropped, and the exporter could, after conversion, receive less than expected. By buying a put on the foreign currency, the exporter can limit potential losses at the strike price of the currency option. No matter how far the foreign currency falls, a long put will set a floor on the exporter’s potential losses.

An exporter will always buy puts to hedge his foreign currency position because his risk lies with a fall in the value of the foreign currency.

In contrast, an importer will always hedge with a call because his risk is with a rising foreign currency, which is equivalent to a weakening of his own currency (the dollar for a U.S. importer). A stronger foreign currency will mean that the foreign goods he has agreed to buy in the future will become more expensive. Moreover, if payments for labor or materials need to be made in the foreign currency, a stronger foreign currency will mean that the importer’s expenses will be higher.

To hedge currency risk, exporters should buy puts; importers should buy calls.

Sample Question 1

A U.S. company buys $20 million worth of optical equipment from a Japanese company, to be delivered and paid for in 60 days. The company decides to reduce its currency risk by acquiring options and p