Options An example of protecting against currency moves with a combination of calls and puts
If you sell product to the U.S., as many Canadian businesses do and want to protect yourself, you are probably asking what to do if the loonie is worth more than a U.S. greenback, which it has been again recently. With many risk-management tools available today, what is the best strategy for you in your situation?
Forward contracts are simple, but are they the most effective tool? It depends on whether now is a good time to lock in prices. With forwards, since you lock in at a fixed price without the potential for gain, there can be a lot of opportunity cost and you can leave a lot of money on the table.
There are other potentially more profitable risk-adjusted option strategies to consider instead of, or in addition to, just forwards. Provided is an example of a risk-management profile we implemented for a client showing why options can often offer a better risk-reward ratio than using only forwards.
Last year at this time, we helped a client who needed to manage his Canadian dollar risk. To better understand their situation, we have included some of the criteria used to determine our best strategy for their needs:
• The client had sold grain in U.S. dollars with payment expected late summer/early fall.
• Given the C$ had moved higher from 1.00 par to 1.045 from March 2011 to April 2011, we wanted to leave some room in the event the C$ pulled back from its recent strong run but still have protection against a move higher.
• At the same time, the client was less concerned about the C$ going much above 1.10 U.S.
• Also, the client would be happy locking in C$ at a much lower level of 1.02.
• We wanted to structure the hedge so there would be little net cost to the client.
Option strategies work best considering all these conditions combined. In early April, with the C$/U.S. exchange rate at 1.0450, we recommended the following to hedge a US$800,000 payment expected in the summer/fall of 2011:
• Buy eight September 1.0500 calls for $16,400 for premium paid including commission and fees as protection against a stronger C$.
• Sell eight September 1.1000 calls for $3,200 for premium received including commission and fees to offset some of the cost of buying the 1.05 calls since the client was not too concerned about C$ moving above 1.10.
• Sell eight September 1.0200 puts for $11,400 for premium received including commission and fees to offset some of the cost of buying the 1.05 calls since the client would be happy to convert his US$ into C$ at 1.02.
• Therefore, it cost $1,800 to implement this $800,000 hedge until September.
In summary, this strategy provided protection from 1.05 all the way up to 1.10, with the opportunity to convert at a better rate if C$ dropped back to 1.02, all at little cost to the client.
So, how did this strategy unfold? As you can see from the chart, the C$ moved sideways to lower in favour of the client. Based on US$800,000, the net benefit of the strategy was $17,320. The main gains came from having the flexibility of an option strategy to convert US$ into a weaker C$ at 1.02 rather than locking in the US$/C$ up at 1.045.
Here’s how the approximate numbers worked:
• The cash currency gain from converting cash US$ to C$ was of $32,720 since the C$/US$ spot rate fell from 1.0450 at the beginning of hedge to 1.0041 at end of hedge.
• The option hedge offset was $15,400, representing the difference between the put sold at 1.02 and the spot rate of 1.0041 as well as all option costs, commission and fees.
• The net gain from hedging with options versus just locking in a forward was therefore $17,320, assuming the client exchanged the cash the same day the hedge was lifted.
This is just one example and it won’t necessarily work this cleanly every time. For instance, if the C$ had moved dramatically lower, significant funds could be required during the course of the hedge to cover the short put until the US$800,000 account receivable was received and the hedge was lifted.
Regardless of the exact strategy you implement for your situation, we advocate a continuous, disciplined, proactive approach to put the odds in your favour over time. Remember, it’s too late to buy fire insurance when your house is already on fire; or, if you can, it will be extremely expensive and difficult to implement. Bottom line, as we like to say: “Manage your risks before they manage you!”