Hedging currency risk with a range forward currency contract
Businesses that are loathe to pay the upfront premium when buying a vanilla currency option can reduce that cost partly or completely, using a range forward currency option or contract.
In essence it involves the purchase of an option whose premium cost is offset by the premium income from selling another currency option.
For example, a UK business exposed to the appreciation of the USD (e.g., it has to make a payment on a specific date in the future) can hedge its exposure by buying a USD call option thereby guaranteeing it will receive no less than the $ strike rate (e.g., $1.50) if the $ appreciates (to say, $1.25).
To pay for the premium, it can sell a USD put option (at a strike of say $1.75). If on the payment date the $ has depreciated beyond this (e.g. to $1.80) then the company will receive in effect $1.75 not the more favourable $1.80
If the $ spot rate at maturity is in the range $1.50 to $1.75, the business uses the prevailing spot rate.
To find out how to use Range Forwards or other currency hedging instruments to manage your business's currency risks, contact Permjit Singh for a free chat without obligation.