How to Hedge With Currency Options

A currency option gives you the right but not the obligation to buy or sell a given currency

When firms or individuals have cash flows denominated in different currencies, they become subject to the currency risk--a risk that their incoming cash flows will fall and outgoing cash flows will rise as a result of adverse exchange rate movements. Currency options can help reduce currency risk. A currency option is a financial instrument that gives you the right but not the obligation to buy or sell a given currency at a certain price by a certain time.

Instructions

1. Determine your foreign exchange exposure. In order to hedge your currency risk, you need to understand what that risk is. What cash flows are threatened by possible exchange rate movements? And what are experts' estimates of the likelihoods of those movements?

2. Learn as much as you can about currency options. Basically, there are two types: Call options allow you to buy currency while put options allow you to sell it.

   Read books on the subject. You can buy books about currency options online or at your local bookstore. You can also borrow them from your public library.

3. Find out what currency options you need to minimize your risks. You should weigh the price of options on the one hand, and the risks these options mitigate on the other. Sometimes it can make sense to buy a currency option, in other situations it can be cheaper to assume the currency risk. Create a list of currency options you need to buy.

4. Find a broker that deals in currency options. A good broker will offer low commission charges. Go with a well-established broker with a lot of clients, and a good reputation. You can check the broker's legitimacy with an industry regulator--the Commodity Futures Trading Commission (CFTC) in the U.S..

5. Open an account with the broker you chose and purchase the necessary currency options. You'll still need to monitor the currency market and if need be adjust the way you manage currency risks. Maybe you will be able to sell some of the the options you will no longer need, or, on the contrary, will have to buy more currency options. Be vigilant.

References

• DeltaStock: Using Currency Options for Hedging
• Investopedia: Currency Option