How to Compare Currency Derivatives & Credit Considerations

Foreign exchange risk management involves the use of currency derivatives, which are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. In order to use currency derivatives to achieve foreign exchange risk management objectives, companies must be able to deal or trade with a credit worthy counterparty such as a bank or financial institution.

Counterparty credit risk is the risk that the counterparty to a contract does not perform, and is involved in any banking activity, including trading currency derivatives. Therefore, both parties in the transaction need to consider the financial condition of their counterparty by quantifying their creditworthiness. It can be helpful to compare key credit considerations between the three most common currency derivatives, which include forward contracts, vanilla options, and zero cost collars.

Forward contracts involve the exchange of two currencies at an agreed upon rate on the date of the contract for settlement on a date more than two business days in the future. A forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate. From a credit perspective, forward contracts usually do not require an upfront exchange of funds, but almost always requires a payment at maturity to settle the asset or liability position of the contract.

Option contracts are financial contracts that give the buyer the right, not the obligation, to buy or sell a quantity of a particular currency at a specific exchange rate, called the strike rate, on or before a pre-arranged date. A purchased option begins its life as an asset in the amount of the option premium paid to the counterparty at inception, and will expire with either a positive value or zero fair value. In other words, options require an upfront payment, but do not require the option holder to make a payment at maturity.

A zero cost collar is a combination of two vanilla options, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. This structure enables the holder to buy or sell a quantity of a particular currency within a specified range of exchange rates between the two option strikes on or before a pre-arranged date. In turn, collars do not require an upfront exchange of funds, but may require payment at maturity if the structure finishes in an asset or liability position.

The two key credit variables to consider are (1) the upfront exchanges of funds and (2) the obligation to make a payment at maturity. Since a forward contract is a firm obligation for a future settlement to be made with no upfront exchange of funds, this derivative has a higher credit risk than a purchased option where upfront premium is paid and there is no obligation for the option holder to make a payment at maturity. Similarly, since a collar may require a payment at maturity to settle the contract, collars are more credit intensive than vanilla options.

Conterparty credit risk became a prominent headline during the financial crisis of 2007–2008, and remains an important factor to consider as credit limits may prohibit a firm or entity from entering into a derivative transaction, particularly in a tight credit economy. When credit constraints inhibit business decisions, firms may need to consider alternative means to transact such as posting collateral. When trading FX derivatives, the acronym KYC, which traditionally stands for Know Your Customer, can be modified to Know Your Counterparty.

If you are interested in learning more about foreign exchange derivatives, credit considerations, and how to hedge using financial instruments, sign up for FX Initiative’s Currency Risk Management Training today. Our educational videos, interactive examples, and webinar events use real world companies such as Apple, Inc. to illustrate aspects of their world class foreign exchange risk management policies and procedures. Mitigating currency risk is a top priority for global businesses, and you can benefit your firm’s bottom line by taking the FX Initiative!

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There’s No Free Lunch with FX Derivatives

Milton Friedman, the American economist who received the 1976 Nobel Memorial Prize in Economic Sciences, wrote a book titled "There's No Such Thing as a Free Lunch" and that saying is particularly applicable for understanding currency derivatives. When selecting a foreign exchange hedge instrument, firms can benefit from recognizing the differences and similarities of common derivatives such as a forward contracts, vanilla options, or zero cost collar option combinations.

The FX Spot & Derivatives course explores the concepts of forward contracts, put and call options, and zero cost collars and examines their pricing variables and payoff profiles. Many firms seek protection from unfavorable changes in exchange rates while also seeking to retain the ability to participate in favorable rate movements. This 1 hour program will reveal the mechanics of the most common currency derivatives, and underscore how “there is no such thing as a free lunch” with FX derivatives.

If you are interested in learning more about foreign exchange deritatives and how they are used in practice, sign up for our Foreign Exchange Risk Management Training today and access our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com.  Learn the fundamentals of currency risk management by taking the FX Initiative for your international business today!

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Done Your Derivative Due Diligence?

Foreign exchange risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using financial instruments or derivatives. In order to effectively use currency derivatives to achieve foreign exchange risk management objectives, firms must recognize their differences and similarities and how they work in practice.

While there are a large number of currency derivatives available in the marketplace, very few of these instruments are employed in routine foreign exchange risk management. The most common currency derivatives include forward contracts, vanilla options, and option combinations. By selecting a derivative from a hedge objective perspective, the confusion often experienced from the endless products available in the market can be avoided.

The following introduction video to the "FX Spot & Derivatives" course addresses the three main learning objectives that are covered throughout this highly informative hour long educational program, which include (1) to explore the concept of forward contracts and recognize their forward point premium or discount and symmetrical payoff profile, (2) to explore the concept of option contracts and recognize their pricing variables and asymmetrical payoff profile, and (3) to explore the concept of option combinations and recognize how structures such as a zero cost collar create a unique payoff profile.

If you are interested in learning more about foreign exchange spot & derivatives and how they are used in routine foreign exchange risk management, sign up for our Foreign Exchange Risk Management Training today and access our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Managing FX risk has become a higher priority for many firms for 2017 and it is now easier than ever to learn the fundamentals of currency risk management. Make this the year to reduce FX risk and reap rewards abroad by taking the FX Initiative for your international business today!

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Cheers to your global organization's continued success in the new year,

The FX Initiative Team
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