Keeping Options Open
Karen Kroll
Published June 8th, 2009
Last month, I wrote about the benefits of exchange-traded instruments, which treasurers can use to hedge their firm's exposure to fluctuations in interest rates and foreign currencies. Of course, there's another option - pun intended - treasurers can use, as well. Over-the-counter instruments, such as forward contracts and options, also offer viable ways to hedge a company's risk. The use of options has grown steadily over the past few years. According to the Bank of International Settlements, the gross market value of over-the-counter foreign exchange derivatives rose from $38 to $75 billion between 2006 and 2008.
Several factors are driving these numbers, says Bob Park, president and chief executive officer with FINCAD, a Vancouver, British Columbia-based developer of financial analytic software. For starters, banks saw a market poised for growth and went after it. Perhaps more importantly, the ranks of businesses operating internationally continue to grow, and most can use protection against currency fluctuations in order gain some control over costs.
To be sure, gaining control can come at a price. Say a treasurer enters into a forward contract to cover goods his or her company will deliver in 180 days. The customer is going to pay in its local currency. So, the treasurer purchases a forward to lock in the current exchange rate. Here's the catch: If, in the interim, the exchange rate moves in the company's favor, the company won't benefit. In effect, the company has exchanged the upside potential of any currency fluctuations for greater control over its expenses, Park notes.
To gain some control over expenses yet maintain the ability to benefit from the upside, the treasurer can instead purchase an option. The option would let him or her lock in an exchange rate, without "giving away the upside," Park explains. If exchange rates moved in the company's favor, the treasurer could just let the option expire without using it.
Again, however, there's a cost - the option premium. This fee has dissuaded many companies, particularly in low-margin industries, from using options, Park notes. "The perception has been that if you devote part of your budget to options and you don't use them, you've squandered the money," he says.
That thinking is beginning to change, given the upheaval in all markets over the past 18 months, Park adds. Increasingly, options are viewed as analogous to insurance. While they may never be used, having them available brings some certainty to a company's expenses and makes planning less of an exercise in dart-throwing.
Another misperception that's slowly changing is the notion - sometimes held by execs or board members who lack a strong financial background - that options are inherently speculative. While it's true that options can be used to boost risk, they also can hedge against it. For an options program to get off the ground, treasurers may need to educate their colleagues about their role in reducing risk.
