Deconstructing Myths About Foreign Exchange Options

by Ian H. Giddy



Although FX options are more widely used today than ever before, few multinationals act as if they truly understand when and why these instruments can add to shareholder value. To the contrary, much of the time corporates seem to use FX options to paper over accounting problems, or to disguise the true cost of speculative positioning, or sometimes to solve internal control problems.

The standard cliché about currency options affirms without elaboration their power to provide a company with upside potential while limiting the downside risk. Options are typically portrayed as a form of financial insurance, no less useful than property and casualty insurance. This glossy rationale masks the reality: if it is insurance then a currency option is akin to buying theft insurance to protect against flood risk.

The truth is that the range of truly non-speculative uses for currency options, arising from the normal operations of a company, is quite small. In reality currency options do provide excellent vehicles for corporates' speculative positioning in the guise of hedging. Corporates would go better if they didn't believe the disguise was real.

Let's start with six of the most common myths about the benefits of FX options to the international corporation -- myths that damage shareholder values.

Myth One. Covered Calls are Safe.

When Dell Computer Company was found to be selling naked currency puts and calls, Michael Dell was condemned for speculating with company money. To escape similar criticism many managements have gone on record as admitting only to covered option writing. Here are the words of Rolls-Royce brass on this topic.

"We do believe that the buying and writing of options can complement our hedging policy. ... We will in no event ever write options if there is no requirement to have the underlying there in the first place -- that is, we will not write naked options."

- Mark Morris, financial risk manager, quoted in "No Fear of Options Here," Corporate Finance, July 1994, p. 44.

What Rolls-Royce fails to recognize is that covered option writing is just as risky as naked option writing. For example, the company that has a yen-denominated receivable, and writes a call, giving someone else the right to buy these yen, ends up with a combination of a long outright position and a short call. The sum of these two is the equivalent to writing a put option on yen. Therefore, the covered writer is a sheer speculator too. More generally, whenever a corporate writes a covered option of one kind (put or call) it is in effect writing a naked option of the other kind. (See Figure 1)

[Hockey-stick diagram] Figure 1. Writing Covered Options. When Rolls-Royce sells sterling puts against the dollars it receives from U.S. sales, it's creating a naked call position. The diagram shows how combining the sale of an option with an underlying position in a currency creates the equivalent of a naked short position in the opposite option.

Myth Two. Buying puts offers riskless potential for gain.

The corporate that says it is using options to hedge a known exposure and then use it to seek riskless upside is in reality in the position of a speculator. Why? Because the company ends up hedging a symmetric currency risk with an asymmetric contract. Figure 2 shows how.

[Hockey-stick diagram] Figure 2. Hedging Long or Short Positions with Options. If Ford is owed Japanese yen by Nissan in payment for exported parts, and buys a yen put to hedge the currency exposure, the company has created a synthetic long call. In general, combining an underlying currency position with a long call or put creates the equivalent of a long position in the opposite option.

The long position is the foreign currency receivable, ostensibly "hedged" with a put option. The sum of the two is equivalent to buying a call. Instead of reducing or eliminating risk, as the spin-doctors would claim, this strategy actually creates another risk exposure.

Myth Three. Options are a great hedge against accounting exposure.

This is surely one of the most pervasive of the six myths. It is the conventional wisdom that if a firm has an accounting exposure in a foreign currency that does not correspond to its economic exposure then they will incur translation gains and losses as the currency rises or falls. The popular remedy for this is to buy forward contracts. There is a fly in the ointment, however. Because the translation gains are bookkeeping entries, while the forward contract may produce real cash losses, which can be hard to justify.

To avoid this prospect the firm hedges its long, say, yen exposure by buying yen put options -- figuring if the yen falls it will have a translation loss that is offset by a real cash gain on the option. Should the yen rise, alternatively, the firm will post a balance sheet gain while the option is allowed to expire -- its premium is treated as a cost of "insurance".

This argument has a kind of superficial appeal, to be sure. If the long foreign currency exposure is merely a fiction, the firm has created a long put position which is subject to the risk of option price fluctuations. If on the other hand one believes that the balance sheet gains or losses have true economic value, then they are symmetrical and we have created a long call position. It might happen, of course, that a firm recognizes these facts but still likes the options hedging idea for purely cosmetic reasons. In which case it must accept that the cost of cosmetics is equivalent to the extent to which a open, unmanaged option's position can add to the variability of real cash flows. And that can amount to a lot of lipstick.

Myth Four. Options are good for avoiding the "d" word.

Suppose a company has real economic FX exposures -- distinct from accounting and translation exposures -- it may nonetheless be driven into options for quite the wrong reasons. Here the culprit is the reluctance of company managers to report derivatives losses of any kind -- even those that are legitimate hedges. Generally Accepted Accounting Practices would force a marking to market, that is to book a loss in forwards or futures whenever the currency moved in favor of their natural position. So managers are drawn to the siren song of options because there is no chance of a loss. The option premium is amortized on a straight-line basis over the life of the option -- just as if it were an "insurance" policy.

Myth Five. Finessing counterparty risks.

There is a kinky shape to an option's pay off. Because buyers of conventional currency options purchase a right but not an obligation. Thus the risk of default is totally on the writer, while the option buyer's creditworthiness is completely irrelevant -- provided he has paid the option premium first! Thus, there may well be a situation faced by a corporate with respect to creditworthiness of a customer that would not support the use of a symmetric derivative, such as a longer term currency swap. So then, the argument goes, the same hedging needs can be met with an admittedly second-best solution -- i.e. options. But remember that such a use is justifiable only because adequate credit lines are not available to the option buyer.

But before option seller shouts hooray, they should consider a sobering fact. There may be cheaper ways for the corporation to reach the same goal. Credit risk can be handled through collaterization, securitization, for example. Credit shifting with options is only one of several routes -- not necessarily the cheapest.

Myth Six. Options offset unpredictable FX inflows.

Marketers of options often claim that currency options are ideal instruments for hedging uncertain foreign currency cash flows, because the option gives the corporation the right to purchase or sell the foreign currency cash flow if a company wins an offshore contract say, but no obligation to do so if their bid is rejected. It has a surface logic: in which a contingent claim offsets a contingent event. The drawback of this approach, however, is that most of the time you have claims contingent on two different events. Winning or losing the contract depends on your competition and a host of "real" factors, while gains or losses on the option are dependent on movements of the currency and its variability.

A firm buying an option to hedge the foreign currency in a tender bid is paying for currency volatility and in fact taking a position in the options market that will not be extinguished by the success or otherwise of its bid. In other words, whether or not the bid is accepted, the option will be exercised if it is in the money at expiration and not otherwise, and the options price will rise and fall as the probability of exercise changes. In buying the "hedge," the bidder is actually purchasing a risky security whose value will continue to fluctuate even after the outcome of the bid is known.

Are Currency Options Ever Useful?

Yes, in certain well-defined situations, but these are situations that, I believe, that few companies seem to grasp. There is one kind of foreign currency cash flow for which the conventional currency option is perfectly suited: that is the rare exception where the probability of a company's foreign currency receipts or payments depends on the exchange rate. Then both the natural exposure and the hedging instrument have payoffs that are exchange rate contingent and a currency option is exactly the right kind of hedge.

By way of illustration, consider an American firm that sells in Germany and issues a price list in German marks. If the mark falls against the dollar, the Germans will buy your doodads, but of course you will get less dollars per doodad. If the mark rises, the clever Germans will instead buy from your distributor in New Jersey whose price list they also have. Your dollar revenues are constant if the mark rises but fall if the mark drops. Perhaps you were dumb to fix prices in both currencies; what you have effectively done is to give away a currency option. This asymmetric currency risk can be neatly hedged with a put option on DM.

A variation on the above could be one where the company's profitability depends in some asymmetric fashion on a currency's value, but in a more complex way than that described by conventional options. An example might be where competitive analysis demonstrates that should a particular foreign currency fall to a certain level, as measured by the average spot rate over three months, then producers in that country would gear up for production and would take away market share or force margins down. Anticipation of such an event could call for purchasing so-called Asian options, where the payoff depends not on the exchange rate in effect on the day of expiration, but on an average of rates over some period.

There are some other situations that could justify the use of currency options. And one of these is averting the costs of financial distress. Hedging can under some circumstances reduce the cost of debt: for instance when it reduces the expected costs of bankruptcy to creditors, or of financial distress to shareholders, or if it allows greater leverage and hence increases the tax shield afforded by debt finance. Where fluctuations in the firm's value can be directly attributed to exchange rate movements, the firm may be best off buying a out-of-the-money currency options. In such a case it would be buying insurance only against the extreme exchange rate that would put the firm into bankruptcy.

Where does that leave us?

The general rule about hedging tools is that specific kinds of hedging tools are suited to specific kinds of currency exposure. Whatever happens to your "natural" positions, such as a foreign currency asset, you want a hedge whose value changes in precisely the opposite fashion. Thus forwards are okay for many hedging purposes, because the firms' natural position tends to gain or lose one-for-one with the exchange rate. (Even this is often untrue.) But the kind of exposure for which foreign exchange options are the perfect hedge are much rarer, because contracts are not won or lost solely because of an exchange rate change. A currency option is the perfect hedge only for the kind of exposure that results from the firm itself having granted an implicit currency option to another party. Usually, currency options offer an imperfect hedge, while plain, boring old forward contracts can do the job more effectively.

An Afternote

 Are Options a Good Way of Taking Limited-Risk Currency Positions?
Frequently corporate treasurers use options to get the best of both worlds: hedging combined with a view. Their actions and statements suggest that many believe currency options are a good way to profit from anticipated moves in the currency. They are not. Option-based positioning is far more complicated than outright long or short exposures. The reason is that the gain or loss from an option is a non-linear function of the currency's value, and that the relationship is not stable but varies with anticipated volatility, with time, and with the level of interest rates. For these reasons, options are not ideal speculative instruments for corporations.
Ian H. Giddy, Professor of Finance
New York University Salomon Center • Stern School of Business
44 West 4th Street, New York 10012
Tel 212 998-0704 • Fax 212 995-4220
Go to Giddy's Web Portal • Contact Ian Giddy at igiddy@stern.nyu.edu