Foreign Exchange Options: The Leading Hedge

Abstract

Foreign exchange options (FXOs) can serve international financial managers in several ways. First, FXOs are essential to hedging “contingent” foreign exchange exposures – the kind of exposure which arises, for example, when a US contractor bids for a contract denominated in a foreign currency. Second, FXOs are used in active foreign exchange exposure management – that is, those cases in which management chooses to take a position on the direction or the volatility of currency movements. In this more speculative use, options can limit downside risk while retaining upside potential for profit. Forwards or futures, by contrast, do not allow the investor to take a view and cap losses at the same time. Third, using FXOs in portfolio management allows managers to construct portfolios according to the specific risk-return profile they desire. Conventional financial instruments allow managers to make tradeoffs only between the risk (or variance) and the return of a portfolio. FXOs, however, make possible the more complex trade-offs described later in this article.