An Insight Into Hedging Against Foreign Currency Volatility Using Options
The foreign currency market is the most volatile financial market in the world. In fact, many seasoned investors and analysts refer to it as the “Wild Wild West” of financial markets. One of the primary reasons it picked up this witty nickname is due to the lack of regulatory oversight that exists in the market. The FX Market is essentially composed of large banking and financial institutions that are spread around the world and connected in a very loose and informal manner. Since the market is decentralized and there is no central clearinghouse as there is in the stock market with the various exchanges, it makes regulation very difficult.
This lack of regulation combined with the enormous amount of liquidity that passes through the FX Market each day, the market tends to move in very volatile swings. Therefore, companies and wealthy investors who are exposed to shifts in currency values have, for decades, engaged in currency options in an attempt to hedge against unfavorable currency swings. For example, if Fortune 500 company Caterpillar, Inc. has a large operation in Japan, then it needs to hedge against the possibility of sharp currency volatility between the Japanese Yen and U.S. dollar. In this article, we are going to discuss how a company like Caterpillar goes about this; however, this example also applies to the small investor who has several thousand dollars invested in a foreign company and needs to hedge against possible currency volatility.
Why Currency Volatility Can Cut Into Real Profits
Let’s break down a simple real-world example. Let’s assume that Caterpillar conducts business in Japan and sells hundreds of pieces of excavation equipment in a year. When they sell these pieces of equipment in Japan, they are selling them in Japanese yen, the currency in Japan. Now, if the U.S. dollar depreciates significantly versus the Japanese yen during the year, then when Caterpillar shifts those yen profits back into U.S. dollars, the real profits will be eroded significantly in proportion to the amount the U.S. dollar has depreciated versus the Japanese yen. Therefore, Caterpillar has to protect itself not in online currency trading, but by buying put and call options on the U.S. dollar in order to hedge against the possibility of wild fluctuations in the USD/JPY exchange rate.
How Corporations Do This
A multinational corporation will generally have tight relationships with a large investment bank or 3rd part institution that will conduct in-depth risk analysis and prescribe a clear plan of action concerning whether to buy put or call options and how much to purchase. A call option will give Caterpillar the right, but not the obligation, to buy a specific amount of currency, and a put option will give Caterpillar the right, but not the obligation, to sell a specific amount of currency in the future. A forex platform can be used to follow the spot price of most international currencies.
Generally a large corporation or sophisticated investor can largely limit his exposure to wild currency exchange volatility by purchasing put and call options on currencies.
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