How Do Companies Use Foreign Exchange?
Companies with operations in more than one currency zone must adopt a foreign-exchange strategy to protect themselves from sudden adverse fluctuations in the value of one of those currencies vis-a-vis the other. One way to do this involves the use of the market for options to sell a given currency, also known as the market for puts.
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Hypothetical
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Suppose you are the chief financial officer of a manufacturing company headquartered in the U.S. with a subsidiary in Chile, where your company sells some of its products. The money received in Chile is paid in Chilean pesos. Due to the onset of a political crisis in Chile, you might well be concerned that there will be a sudden downward movement in the days to come in the value of the Chilean currency vis-a-vis the U.S. dollar. If that happens, you may well fail to meet your revenue projections for the coming quarter. You could over time increase your prices in Chile to compensate for the cheapening of the currency, but you don't know how the Chilean consumers will respond to that, and in the interval you are still taking a revenue loss when you convert the pesos on hand into dollars.
Resolution: Buying a Put
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One way you can protect your company against such an event (in other words, create a currency hedge) is by buying options to sell your Chilean pesos. Options to sell are known as puts. (Options to buy, on the other hand, are calls.)
If you are right to be concerned, and the peso does decline, your company will be able to exchange the pesos paid for your product at the contract's prearranged price (the strike price), thereby cutting the losses.
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Misplaced Worry
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Suppose, though, your concern was misplaced, and there is no sharp drop in the value of the peso. Still, you lose only what you paid for the puts, a fraction of what was at stake, and the loss is generally tolerable for the benefit of the security it provided -- akin to the "loss" a homeowner suffers by virtue of paying fire insurance premiums because his house never catches fire.
Another Scenario
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On the other hand, suppose that the subsidiary in Chile is a mining concern, not a marketing operation. Suppose your company pays contractors in Chile for their work in connection with the mine. In this context, your concern won't be with a sudden fall in its value, but with the threat of a sudden rise.
In this case, you can sell puts. In effect, you'd be writing a contract promising to accept pesos at a given rate -- but the contract rate to which you're committing yourself, the strike price, is less advantageous than the present market rate, or any higher rate that the market might reach if your worries of a too-strong peso prove valid. So if the peso does head higher, the buyers of your puts won't exercise them, they will expire, and your company will keep the premiums.
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