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Business Finance


Greece is a good example of how one country’s economic activity can have a ripple effect on currency markets around the world. Globalization has made it easier for businesses to tap into overseas opportunity, but also added new complexity to the management of cash flow. Even small movements in the exchange rate can have an impact on your bottom line.

Currency risk management used to be associated with large companies, but today many small businesses also realize that it’s important to have a plan for dealing with currency risk.

Currency Options are one of the most common tools available for managing risk. But they are often viewed as overly complex, and best suited to larger corporates who have the time and resources to manage them properly.

The truth is that there are a range of Currency Options tools available to meet the needs of any sized business. It’s time to shed some light on the basics of Currency Options and their benefits.

A blended approach to your needs

Before diving into the world of Currency Options, it’s important to assess the specific needs of your business, and put together a unique strategy to help achieve your goals.

The strongest risk management strategies often combine a range of currency hedging tools including Forward Contracts and Market Orders. To succeed in today’s marketplace, you have to identify the right combination for you.

The first thing you should do is assess where your currency exposures exist and what you currently do to protect your profits from volatility. Once you understand what your foreign invoices cost in local currency, and the impact of fluctuation on your margins, you can begin to define some goals to manage this risk.

You might find it makes sense to cover half of your currency exposure using an Options tool, and the other half with a Forwards Contract. Or, alternatively it could make sense to cover all of your exposure using a combination of Options tools. No two businesses are the same, and every risk management strategy will be unique.

How will Currency Options help protect your business?

Options are a popular way to mitigate the impact of fluctuating currencies on your profits. They help you prepare for future foreign currency expenses and stabilize cash flow, which helps you budget for the future with confidence.

The basic principle of each Option tool is the same. You lock in an exchange rate to protect your business from volatility, but you also get the opportunity to take advantage of positive shifts in the currency market. You can think of Currency Options as an insurance policy against undesirable market movements. Typically you would lock in a rate just below the market spot rate.

Options offer flexibility aligned to your business goals, which is why businesses of all sizes can incorporate these tools into their risk management plans.

Breaking down your Options

The simplest Currency Option is a Vanilla Option. This gives you the choice of whether or not to sell one currency and buy another at a specified exchange rate (the protection rate) on a date in the future (the expiry date).

At the expiry date, if the prevailing market rate is less favourable than your protection rate, you will exercise your right to deal. However, if the spot rate is more favourable you can choose to let your Option expire and deal at the more advantageous spot rate.

To take out a Vanilla Option you must pay a non-refundable amount of money up front (the premium). You can avoid paying a premium by using a Zero Cost Option Structure. These tools are complex, and may require you to deal some portion of funds at expiry, and can also be tailored to your both exact requirements and market conditions.

Forward Contracts versus an Option

A Forward Contract gives you the right to sell one currency and buy another at a specified exchange rate on a date in the future. Unlike an Option, if the market moves in your favour, you are still obliged to buy and sell at the specified rate. You do not have the flexibility to benefit from the market movement.

Where the Forward has no upfront cost, the Option often requires a non-refundable premium, even if you choose not to exercise your Option on the expiry date. The premium is a known cost that can be budgeted for, so there are no surprises.*

                             Upfront cost    Known rates    Participate in favourable markets
Forward contract: __________    __________    __________________________
Option:                 __________    __________    __________________________

* This comparison is a general overview of a basic Vanilla Currency Option versus a Forward Contract. Options with Zero Cost Structures typically have other advantages and disadvantages to consider. Always use your independent judgment in evaluating hedging tools based on your business needs.

The right Option for your business

Options are very flexible instruments and there are a number of ways they can be tailored to suit your needs. Here are some of the most common features that can be tailored.

Protection rate
Choose the rate you need to stay within to protect your profit margins against fluctuation. As a general rule, the more favourable the protection rate, the less upside potential there will be and vice versa.

Barrier or trigger rate
Setting a barrier or trigger rate can help flex your Option but if this rate is breached it triggers a contingent obligation that either initiates or removes a previously set hedge

Participation percentage
While some Options provide 100% participation in favourable market shifts up to a given level, others only offer participation on a proportion (the participation percentage). If you reduce the participation percentage, the barrier rate and or the protection rate can be improved.

Adding leverage
Lower your protection relative to your potential obligation. This improves the initial terms on offer, but will worsen the potential outcome if the market moves adversely. Adding leverage is not suited to all businesses and should only be done with the guidance of a risk management specialist.

Business Finance 

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