9 October Due Diligence & Distinguishing FX Derivatives October 9, 2017By FX Initiative FX Derivative Speculator, FX Spot & Derivatives, General Accounting, Cash Flows, Compare, Continuing Professional Education, Contract, CPE, Currency, Derivatives, Foreign Exchange, Forward Contracts, FX, FX Initiative, Management, Option Contracts, Risk, Strategy, Zero Cost Collars, Due Dilligence 0 Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions. At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives. The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, (2) vanilla options, and (3) zero cost collars. Therefore, to achieve the 2 most common hedging objectives using the 3 most common currency derivatives, it is helpful to compare and contrast how each derivative achieves each hedging objective as follows: 1) Forward Contracts Objective 1: Minimizing Earnings Volatility - Forwards are particularly attractive for firms that seek a symmetrical payoff profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by far the most effective derivative for eliminating foreign exchange gains and losses to the greatest extent possible, and are used overwhelmingly in practice for all types of FX hedges. Objective 2: Preserving Cash Flows - Forward contracts do not require an upfront premium to be paid, unlike an option. However, a forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate, which may require a cash payment to be made in the future to settle the contract. 3 Distinguishing Characteristics: 3 key distinguishing characteristics of forward contracts are their forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile relative to the spot foreign exchange rate. 2) Option Contracts Objective 1: Minimizing Earnings Volatility - Options are particularly attractive for firms that seek an asymmetrical payoff profile relative to the spot foreign exchange rate, where the hedge secures the value of an underlying position against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves. Options do not provide the same degree of offset in earnings as a forward due to its asymmetrical payoff profile, and tend to be used for longer dated and/or uncertain exposures. Objective 2: Preserving Cash Flows - A purchased vanilla option requires a cash premium to be paid to the counterparty at inception, which can be a deterrent compared to a forward contract. However, an option will always expire with either a positive intrinsic value or zero fair value at maturity, ensuring no future cash payment is required by the option holder to settle the contract. 3 Distinguishing Characteristics: 3 key distinguishing characteristics of vanilla option contracts are the premium paid upfront, the asymmetrical payoff profile relative to the spot foreign exchange rate, and the lack of obligation to make a payment at maturity. 3) Zero Cost Collars Objective 1: Minimizing Earnings Volatility - Zero cost collars are particularly attractive for firms that seek to establish a predefined range of foreign exchange rates where the value of the hedged FX transaction is secured on the downside by the collar “floor” and limited to the upside by the collar “ceiling" or "cap”. Zero cost collars provide less downside protection and less of an offset in earnings relative to a forward contract, but allow for participation in favorable market moves like an option contract with no upfront premium. Objective 2: Preserving Cash Flows - Zero cost collars do not require an upfront premium to be paid by combining two vanilla options, (1) a purchased out of the money option and (2) a sold out of the money option, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. However, a collar has the potential to finish in a zero fair value, asset or liability position at maturity, which may require a future cash payment to be made to settle the contract. 3 Distinguishing Characteristics: 3 key distinguishing characteristics of zero cost collars are the ability to participate in favorable foreign exchange rate movements with no upfront cost, the reduced downside protection relative to a forward contract, and the unique payoff profile of the collar range relative to the spot foreign exchange rate. Overall, each company must decide their FX hedging objectives and strategy for achieving those objectives that balances minimizing earnings volatility and preserving cash flows. There is no one prescribed method for selecting a FX derivative, and firms can benefit by approaching the selection of a derivative from a hedge objective perspective. As the late, great economist Milton Friedman said, “there is no free lunch” in economics, and when selecting a FX strategy, firms can benefit from recognizing the tradeoffs, differences and similarities of how the 3 most common currency derivatives can be used to achieve the 2 most common FX hedging objectives. To learn more about FX derivatives, you can explore our previous blog post on “How to Compare Currency Derivatives & Credit Considerations” and sign up for FX Initiative’s currency risk management training. Our FX Spot & Derivatives Course deconstructs forward contracts, option contracts, and zero cost collars to help you select an optimal hedge instrument. Additionally, our FX Derivative Speculator illustrates the economics and accounting of derivative positions to compare and contrast the payoff profiles, cash flows and accounting entries under virtually any FX rate scenario. Start doing your derivative due diligence today by taking the FX Initiative! Are you curious how forwards, options, and zero cost collars work in practice? Click here to learn from real-world examples! Cheers, The FX Initiative Team support@fxinitiative.com Related Posts 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 ... 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 ... Discover the Different Types of FX Derivatives Do you want to discover the different types of FX derivatives in detail? FX Initiative’s FX Spot & Derivatives course will help you distinguish the different type of FX derivatives firms employ to effectively hedge FX risk. This program provides a comparative analysis of FX derivatives with simulated examples to demonstrate the instruments your firm can use. Get started with our foreign exchange risk management training, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Start Training > Download the PDF How to Price Cryptocurrency (Bitcoin) Derivatives? Bitcoin (BTC) broke through to a record high of $11,831 over the weekend as volatility in the cryptocurrency continues to rise. Amidst these large and recent price fluctuations, the CME Group (Chicago Mercantile Exchange & Chicago Board of Trade) announced that its new bitcoin futures contract will be available for trading on December 18, 2017. While the valuation of traditional currency and equity derivatives is well established among professionals working in the financial industry, the introduction of the first cryptocurrency bitcoin derivative poses valuation questions as it relates to a new pricing model. Simply put, how are cryptocurrency derivatives priced? Financial engineering is a continuously evolving discipline designed to introduce and test new products, pricing models and hypotheses. Currently, equity futures are typically priced using variables such and the risk free interest rate and dividends, and currency forwards are priced based on the foreign and domestic interest rate differential between the two currencies in the pair. Additionally, equity options are typically priced using the Black–Scholes option pricing model, and currency options are priced using the Garman–Kohlhagen option pricing model. All ... 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. Want full access? Click to subscribe today! 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 ... Practice Pricing FX Derivatives Would you like to practice pricing FX derivatives? The FX Derivative Speculator is a risk modeling tool you can use to compare and contrast pricing variables and payoff profiles of FX derivatives to analyze the economic impact on cash flows and the financial reporting implications under virtually any FX rate scenario. This customizable and interactive web application quickly and easily demonstrates how higher and lower interest rates determine the forward rate, how the upfront premium of an option is priced and accounted for, and how a zero cost collar blends characteristics of forwards and options. Get started with our foreign exchange risk management training, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Start Training > Download the PDF Comments are closed.