Hedging Strategies using Currency Options- How to do it?

Published on Friday, August 24, 2018 by Chittorgarh.com Team | Modified on Thursday, November 14, 2019

What is Currency hedging?

Hedging is one of the key benefits of the trading in currency options. There are many people in the country who hold foreign currency in substantial amounts. Exporters and Importers also get impacted by increase/decrease in the exchange rates of the currency. You can take a position in the currency options market to protect your existing holdings from any unwanted price movements. Such positions in the Options is called currency hedging.

Currency Option Hedging Strategy For Import Transactions

Suppose you want to import goods from the United States. Your order will be delivered after 3 months and you will pay for it on delivery. Now any increase in the exchange rate of USD will result in increasing the price of your order. To protect yourself from such an increase, you buy a USDINR Call Option at a strike price of 65.00. The current spot price of USD is Rs 63.00. The premium is Rs 0.30 and the option will expire in 3 months. The lot size is 1000.

When you buy a Call option, you gain when the spot price is higher than the strike price of the option.

Now let's see how your trade gets affected in various scenarios-

If USD exchange rate increases to Rs 67.00

You bought the Call option when the dollar value was Rs 63.00. Now, on the date of expiry, the dollar value is Rs 67.00, an increase of Rs 4. Your strike price for the option was Rs 65. So, your profit would be-

[(Closing Price of USDINR on expiry-Strike Price)-(Premium)] X Lot Size

[(67-65)-(0.30)] X 1000= 1700

If USD exchange rate decreases to Rs 61.00

You bought the Call option when the dollar value was Rs 63.00. Now, on the date of expiry, the dollar value is Rs 62.00, a decrease of Rs 1. Your strike price for the option was Rs 65. So, your loss should be-

[(Closing Price of USDINR on expiry-Strike Price)- (Premium)] X Lot Size

[(62-65)-(0.30)] X 1000= -3300

However, since Options gives you the right but not the obligation to exercise the contract so you choose to allow the contract to expire worthlessly. The premium of Rs 300 will only be your loss.

So currency hedging helped you completely or partially negate the losses which you could have incurred in your business due to an increase in the dollar value. The increase in the cost of your order is recovered by earnings from the Call option.

Currency option strategy for Export transactions

Suppose you want to export goods to the United States. You will deliver the order after 3 months and you will be paid for it on the delivery. Now any decrease in the exchange rate of USD will result in decreasing the value of your order. You will earn less than expected from the order. To protect yourself from such a movement in the exchange rate, you buy a USDINR PUT Option at a strike price of 65.00. The current spot price of USD is Rs 63.00. The premium is Rs 0.30 and the option will expire in 3 months. The lot size is 1000.

When you buy a Put option, you gain when the spot price is lower than the strike price of the option and accumulate losses when the spot price is higher than the strike price of the option.

Now let's see how your trade gets affected in various scenarios-

If USD exchange rate decreases to Rs 61.00

You bought the Put contract when the dollar value was Rs 63.00. Now, on expiry, the dollar value is Rs 61.00, a decrease of Rs 1. The strike price for your Put contract was Rs 65. So, your profit would be-

[(Strike Price-Closing Price of USDINR on expiry) - (Premium)] X Lot Size

(65-63-0.30) X 1000= 1700

If USD exchange rate increases to Rs 68.00

You bought the Call option when the dollar value was Rs 63.00. Now, on the date of expiry, the dollar value is Rs 68.00, an increase of Rs 5. Your strike price for the option was Rs 65. So, your loss should be-

[(Strike Price-Closing Price of USDINR on expiry) - (Premium)] X Lot Size

[(65-68) - (0.30)] X 1000= -3300

However, since Options gives you the right but not the obligation to exercise the contract so you choose to allow the contract to expire worthlessly. The premium of Rs 300 will only be your loss.

So currency hedging helped you negate the losses which you could have incurred in your business due to a decrease in the dollar value. The decrease in the value of your order is recovered by earnings from the Call option.