Using Options to Hedge Other Currency Risks.
Currency options are a valuable risk management tool in other situations as well. Conventional transaction-exposure management says you wait until your sales are booked or your orders are placed before hedging them. If a company does that, however, it faces potential losses from exchange rate movements because the foreign currency price does not necessarily adjust right away to changes in the value of the dollar. As a matter of policy, to avoid confusing customers and salespeople, most companies do not change their price list every time the exchange rate changes. Unless and until the foreign currency price changes, the unhedged company may suffer a decrease in its profit margin. Because of the uncertainty of anticipated sales or purchases, however, forward contracts are an imperfect tool to hedge the exposure.
For example, a company that commits to a foreign currency price list for, say, three months has a foreign currency exposure that depends on the unknown volume of sales at those prices during this period. Thus, the company does not know what volume of forward contracts to enter into to protect its profit margin on these sales. For the price of the premium, currency put options allow the company to insure its profit margin against adverse movements in the foreign currency while guaranteeing fixed prices to foreign customers. Without options, the firm might be forced to raise its foreign currency prices sooner than the competitive situation warranted.
Application Hewlett-Packard Uses Currency Options to Protect Its Profit Margins
Hewlett-Packard (H-P), the California-based computer firm, uses currency options to protect its dollar profit margins on products built in the United States but sold in Europe. The firm needs to be able to lower LC prices if the dollar weakens and hold LC prices steady for about three months (the price adjustment period) if the dollar strengthens.
Suppose H-P sells anticipated euro sales forward at €1/$ to lock in a dollar value for those sales. If one month later the dollar weakens to €0.80/$, H-P faces tremendous competitive pressure to lower its euro prices. H-P would be locked into a loss on the forward contracts that would not be offset by a gain on its sales because it had to cut euro prices. With euro put options, H-P would just let them expire, and it would lose only the put premium. Conversely, options help H-P delay LC price increases when the dollar strengthens until it can raise them without suffering a competitive disadvantage. The reduced profit margin on local sales is offset by the gain on the put option.
Currency options also can be used to hedge exposure to shifts in a competitor’s currency. Companies competing with firms from other nations may find their products at a price disadvantage if a major competitor’s currency weakens, allowing the competitor to reduce its prices. Thus, the company will be exposed to fluctuations in the competitor’s currency even if it has no sales in that currency. For example, a Swiss engine manufacturer selling in Germany will be placed at a competitive disadvantage if dollar depreciation allows its principal competitor, located in the United States, to sell at a lower price in Germany. Purchasing out-of-the-money put options on the dollar and selling them for a profit if they move into the money (which will happen if the dollar depreciates enough) will allow the Swiss firm to partly compensate for its lost competitiveness. The exposure is not contractually set, so forward contracts are again not as useful as options in this situation.