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Corporations
Myths That Aren't
Christopher S. Bourdain, a corporate currency risk management specialist at Chase Manhattan Bank,
responds to an article by NYU professor Ian Giddy in our February issue.
In his "Six Common Myths About FX Options," Professor Ian Giddy discusses so called "common
myths" that are used to promote corporate use of FX options. He then takes issue with these six
"myths," largely in an attempt to demonstrate that for corporations "the range of truly
non-speculative uses for currency options...is quite small." I will attempt to show the error in some of
Professor Giddy's assertions.
"Myth" One:
"Writing covered options is safe, and can earn money, as long as the company has the underlying
currency to deliver."
Believe it or not, this "myth" is 100 percent true! At least covered writing does not increase risk if one
already has the underlying position. The key point here is that writing options never constitutes a
hedge as it offers no protection against downside risk. At best, it caps out one's upside potential on
an underlying position beyond the chosen option "strike" level-exactly as a forward contract would.
Giddy shows how a long-yen/ short-yen call position equates to being short a "naked" yen put when
looked at in isolation: in either instance, the optimal payout (maximum receipt of dollars) occurs if
the yen remains steady or strengthens, while an adverse outcome (fewer dollars received) occurs
with a yen decline.
However, Giddy's belief that "covered option writing is just as risky as naked option writing" applies
only if the underlying currency position is speculative to start with, i.e. created purely for the
purposes of trading gain. It is not fair at all to say that "the covered option writer is a sheer
speculator too" about corporations whose currency positions are generated by ongoing foreign sales
or investments, since it is no more risky nor any more or less speculative than choosing to remain
unhedged. Indeed, writing covered options can be an appropriate strategy for a corporation which
has already consciously chosen to remain unhedged on certain exposures, and which secondarily
might elect to "cap out" its upside to generate premium income.
In any case, in the "real world," it is rare to see large U.S. corporations writing covered options in
isolation without addressing their downside risk in some way. Much more typically, they will only
write options to help defray the cost of purchasing some other options, which provide the true
hedge.
"Myth" Two:
"Buying puts or calls to hedge a known foreign currency exposure offers upside potential without the
risk of speculating on the currency."
This "myth" is also true. Giddy shows how in isolation, a long-currency/long-put position equates to
a long-call position, because the optimal payout either way occurs when the currency strengthens.
Yet he strangely argues that a corporation which is long currency from a business operation is a
"speculator" when it buys puts to retain the ability to benefit from a declining dollar while securing
against a dollar rally. Implicitly the professor seems to suggest that it is "speculative" for a
corporation to sell outside its home country because doing so creates currency positions.
To me a worse dereliction of fiduciary duty would occur if a corporation believes that rates are likely
to improve and that FX option premium levels are cheap relative to the upside, but then nonetheless
puts on a forward contract to hedge a currency exposure. Such use of forwards implies a contrary
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belief, i.e. that current rates are optimal, and runs the risk of locking the user into obligations to
settle at what could end up being unattractive rates. If we compare the payout graphs of options
versus forwards, I would argue that eliminating the downward half of the picture beyond the
premium cost while retaining the upward half is indeed a reduction of risk and is therefore almost
always an alternative worth considering.
"Myth" Three:
"Options are a great hedge against accounting exposure."
This surely is not really a "common" myth, since there is in fact no "great" hedge against earnings or
balance sheet translation risk. The very concept of hedging such risk is the subject of ongoing
debate, because any class of hedge instrument ultimately leaves the user at risk of putting out cash
against a non-cash exposure. U.S. corporations that do choose to hedge such exposures tend to be
those for whom non-dollar earnings and/or assets represent more than 40 percent of the total. For
such firms swings in currency values can have a material impact on their reported financial
condition.
As Giddy states, using forwards to hedge accounting risk "can produce real cash losses that can be
hard to justify." Because of this, some firms have found options to be a more palatable means to
hedge such risk. Using options they can continue to bear some degree of translation risk acceptable
to them by choosing an out-of-the-money strike price, while protecting against further deterioration
in translated income or net assets beyond some chosen "worst-case" level-all at a known maximum
cash cost (the premium). Giddy's final remark here, that an "open, unmanaged option's position can
add to the variability of cash flows," is off the mark, since by definition the cash cost of a standard
option is known up front and limited.
"Myth" Four:
"Options offer a useful way to hedge foreign currency exposures without the risk of reporting
derivative exposures."
Real losses on a purchased option can never exceed the premium paid, but a big rise and
subsequent fall in an option's value over different reporting periods could create large apparent
losses on a corporation's books, depending on the accounting treatment. It is true that when
corporations are looking to hedge certain types of non-transactional exposures, the accounting
treatment for options can sometimes carry advantages versus the treatment of forward contracts.
However, if used to hedge an economic exposure such as Giddy describes, options would in fact be
subject to mark-to-market accounting, and would have to be reported as derivative exposures.
"Myth" Five:
"Selling an option is better than using forwards or swaps when the counterparty is risky, because the
option buyer cannot default."
In a vacuum, it is true that an option seller has no mark-to-market risk exposure to the buyer,
because the buyer would only exercise at maturity if the option is at a gain. (An option buyer can still
default on settlement, but this risk can be addressed with various "netting agreements.) However, I
have never heard anyone make this supposedly "common" argument to generate corporate
business, because selling options does not provide a hedge against downside risk.
In the real world, corporations typically write and buy options simultaneously, their prime aim being
to cover downside risk, and they favor the convenience of dealing where they can get both done.
Pricing works out better this way as well: a buy/sell "combo" bears less inherent risk for a bank than
doing a single option, so banks invariably put better pricing on such "combos." Corporations that
have credit concerns about a bank will simply avoid dealing with them at all.
"Myth" Six:
"Currency options offer the ideal way to hedge uncertain exposures such as contract bids."
Giddy makes a strange argument against this statement, suggesting that it is somehow bad to use
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an option to hedge a contract bid because its "value will continue to fluctuate even after the outcome
of the bid is known," and that this is "risky." The riskiness argument is a false one, because the
maximum potential loss on an option (the premium) is known and prepaid.
To be sure, it could happen that a corporation loses a contract bid but ends up with a gain on an
option that is no longer needed as a hedge. However, surely an occasional windfall in this scenario
is better than the substantial loss a corporation could incur if: 1) it wins the contract but loses money
being unhedged against the currency risk, or 2) it loses the contract but loses money being locked
into a forward FX contract at a bad rate. My own view is that the more uncertain a potential future
cash flow, the stronger will be the argument for using options if one wishes to hedge such risk (the
most common alternative being to remain unhedged).
Conclusion:
Professor Giddy seems to believe that corporate use of FX options is generally "speculative" and
therefore bad, and that only forwards are a viable means of hedging FX exposures. He also seems
to believe that accounting translation risk is somehow fictitious and less needful of hedging.
I would argue that remaining unhedged or using forwards can in fact be more speculative than
purchasing options, as the former implies speculation that rates will improve, while the latter implies
speculation that rates are already at their optimal levels. Both entail the risk of substantial real loss
(in the first instance) or substantial loss of opportunity, competitive advantage or cash outlay (in the
second instance).
Purchase of options implies a more limited speculation, i.e. that future rate moves will exceed the
option's upfront price and thereby justify the expenditure involved in maintaining the upside
potential-which is the true value of an option relative to a forward. Meanwhile, writing covered
options does not increase risk in any way versus remaining unhedged, but rather only caps out
potential future advantage exactly as would a forward contract.
Giddy is correct in suggesting that many option users need to better understand how options can
alter a financial risk profile, and under what circumstances options can be an appropriate solution in
their particular hedging programs and possibly add to shareholder value. However, by ringing
alarms where none need to be rung, Professor Giddy does a disservice both to users and to
providers of these valuable financial risk management tools.
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