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HMRC internal manual

Corporate Finance Manual

Understanding corporate finance: derivative contracts: hedging foreign exchange risk

Hedging exchange risks through derivative contracts

A common way of hedging currency risks is by means of forward currency contracts. For example, the UK company discussed at CFM13390 (which knows it has to pay a €100,000 invoice in 30 days time) might arrange with its bank to buy €100,000 at the 1-month forward rate, for delivery in 30 days’ time.

Suppose that the company contracts with the bank to buy the €100,000 for £65,000. If €100,000 could be bought in the spot market for £64,800 when the invoice falls due for payment, the company will be worse off than if it hadn’t entered into the forward contract. On the other hand, if €100,000 turns out to be worth say £65,500, the company could be better off. The important point is that by taking out the forward contract, the company has certainty. It knows in advance exactly how much, in sterling terms, it is going to have to pay and is protected from unpleasant surprises.

Currency options provide an alternative means of hedging exchange risk. In the above example, instead of entering into a forward contract to buy €100,000, the company might instead decide to buy a euro call option from its bank, giving it the right - but not the obligation - to buy €100,000 at a predetermined strike price. The table below summarises how the option differs from a forward contract.

Forward contract Option
The company is obliged to buy the euros at the agreed price, even if that is dearer than the spot price. The company has the right to buy the euros at the strike price, but no obligation. If, for example, the strike price for the €100,000 was £65,000, but they could be bought for £64,800 in the spot market, the company could simply abandon the option and buy the necessary euros at spot.
The company knows in advance how much it will have to pay for the euros. The company fixes a maximum price that it must pay for the euros.
The company may find itself either better or worse off than if it had bought the euros in the spot market. Its potential ‘loss’ or ‘profit’ is unlimited. For example, if its contracted to buy €100,000 for £65,000, it will have ‘lost’ £10,000 if the spot price for the €100,000 is £55,000, but ‘gained’ £10,000 is the spot price is £75,000. There is still unlimited profit potential, but the maximum amount the company can lose is limited to the premium it has paid.
The company must take delivery of the currency on the specified day. An option can be written to have more flexible terms, so that the company can choose when it wants to exercise the option.

CFM13410gives an example of hedging with a currency option.

Where companies use currency options to hedge, they almost always use an over the counter product (CFM13050). It is possible to hedge with traded currency options (or futures), but this is less usual.