2. How does the FX Exposure arise
Ways to hedge FX Exposure
• Spot
• Forward
• Option
• Compound Options
Alternative to reduce hedging cost
Conclusion
2
3. XYZ is Bidding for a project in India
Project bid in Indian Rupee
Revenue after 1 year, Bid Award known after 1 month
Significant costs in USD or EUR
Pricing sensitive to landed INR cost variations
Current Rate to buy USD sell INR 1 year later (Forward
Rate)
= 45.75 INR per 1USD
Current Rate to buy EUR sell INR 1 year later (Forward
Rate)
= 56.60 INR per I EUR
3
4. One month from now, bid is
awarded. No USD/INR hedge
done
Forward @ 46.50
o Variation from earlier estimate=(46.50-
45.75)= 0.75p
o Increment Cost= (0.75/45.75)=1.64%
Forward @ 45.00
o Variation from earlier estimate=(45.00-
45.75)= -0.75p
o Cost Savings= (0.75/45.75)=1.64%
One month from now, bid is
awarded. No EUR/INR hedge
done
Forward @ 58.00
o Variation from earlier estimate=(58.00-
56.60)= 1.40p
o Incremental Cost= (1.40/56.60)=3.00%
Forward @ 55.20
o Variation from earlier estimate=(55.20-
56.60)= -1.40p
o Cost Savings= (1.40/56.60)=3.00%
There are two variables-USD/INR and EUR/USD
4
5. • Spot= Buy USD against INR. Buy EUR against USD.
When?
o At Bid Stage?
What if the bid is not awarded? Unwanted Position. Exposed to
movement in USD/INR and EUR/USD
o At Award Stage?
Spot Rate may be different from rate at which the tender was priced
What if the spot rate on revenue receipt date is different
Don’t have INR, need to borrow INR, Cost of borrowing?
o At actual time when import need to be paid for?
What if the rate is different from the rate the tender was priced
5
6. Buy USD against INR, Buy EUR against USD for
the actual date of payment
When?
o At Bid Stage?
What if the bid is not awarded? Unwanted Position.
o At Award Stage?
Rate may be different from rate at which the tender
was priced
What if the spot rate on payment date is different ?
Opportunity Loss
6
7. • Buy EUR Call USD Put Strike (FWD Rate) expiry 1 Year
Gives you right to buy EUR sell USD at a rate of (Current Forward Rate
=1.2370.) It is a right, not an obligation
Cost 3.50% of EUR Notional.
• Buy USD Call INR Put Strike (FWD Rate) expiry 1 Year
Gives you right to buy USD sell INR at a rate of (Current Forward Rate
=45.75) It is a right, not an obligation
Cost 1.65% of USD Notional.
7
8. If the bid is awarded
If spot at end of 1 year is above
45.75, exercise the option, buy
USD sell INR at a rate of 45.75
If spot at end of 1 year is below
45.75, buy USD sell INR in the spot
market at a better rate
If the bid is not awarded
Long a USD call INR Put
Sell back the option to recover
some cost
Hold the option position to
potential gains later
If the bid is awarded
If spot at end of 1 year is above
1.2370, exercise the option, buy
EUR sell USD at a rate of 1.2370
If spot at end of 1 year is below
1.2370, buy EUR sell USD in the
spot market at a better rate
If the bid is not awarded
Long a EUR call USD Put
Sell back the option to recover
some cost
Hold the option position to
potential gains later
8
9. • Buy a right to buy an option
Buy a right to buy EUR Call USD Put strike 1.2370 for expiry 1 year
from now by paying a cost of 6% on Bid-Award Date. Pay 1% cost
today.
Option does not come alive unless you pay 6% on Bid-Award Date
Total potential cost= 7%
9
10. If Bid is awarded
Exercise the compound option by paying 6%
Buy another hedge- spot, forward or another option if it is
cheaper
If Bid is not awarded
Walk away from compound option. Loss only 1%, the initial
premium paid
Exercise the compound option by paying 6% if the option is
worth more. The option can be sold for gains.
10
11. • Total premium tends to be expensive
• Initial premium can be chosen (typically low). Lower
initial premium would lead to a higher final
premium
• Not available in all currency pairs, so USD/INR not
mentioned.
11
12. Hedging with Options
Right to Buy or Sell
Unlimited Profit Potential
Offsets Loss on Exposure
Limited Loss Potential
Allows Profit on Exposure
Premium Cost Known upfront
Hedging with Forwards
Obligation to Buy or Sell
Unlimited Profit Potential
Offsets Loss on Exposure
Unlimited Loss Potential
Offsets Profit on Exposure
Opportunity Cost initially
Unknown
12
13. • Options carry a cost because they limit the
downside and offer unlimited upside
• To reduce cost, consider
having some downside(risk reversal)
give up some gains on upside (spread)
Or do both ! (seagull)
13
14. Buy EUR Call USD Put Strike 1.2670
Right to buy EUR sell USD at 1.2670 USD per 1 EUR
Sell EUR Put USD Call Strike 1.2120
Obligation to buy EUR sell USD at 1.2120 USD per 1 EUR
Zero Cost
Scenario at expiry
Rate above 1.2670 : Buy EUR at 1.2670, no worse
Rate between 1.2120-1.2670 : Buy EUR in the market
Rate below 1.2120 : Buy EUR at 1.2120, no better
14
15. Price the Tender at 1.2370
If the bid is awarded
Keep the options as a hedge
If the bid is lost
Sell of the option position.
There is potential for unlimited gains and losses but less severe than in
case of a forward.
15
16. Buy EUR Call USD Put Strike 1.2670
Right to buy EUR sell USD at 1.2670 USD per 1 EUR
Sell EUR Call Put USD Strike 1.3070
Obligation to Sell EUR buy USD at 1.3070
Cost 1% of Notional
Scenario at expiry
Rate below 1.2670 : Buy EUR from Market
Rate between 1.2670-1.3070 : Buy EUR at 1.2670
Rate above 1.3070 : Buy EUR at 1.2670, sell USD at 1.3070, net
receive 0.0400 USD per 1 EUR. Buy EUR
from market for own use.
16
17. • Price tender at 1.2370
• If the bid is awarded
Keep the options as a hedge
• If the bid is lost
Sell of the option position to reduce expenditure
17
18. • Buy EUR Call USD Put Strike 1.2470
Right to buy EUR sell USD at 1.2470 USD per 1EUR
• Sell EUR Call USD Put Strike 1.3170
Obligation to sell EUR Sell USD at 1.3170
• Sell EUR Put USD Cal Strike 1.1970
Obligation to buy EUR sell USD at 1.1970
• Zero Cost
18
19. • Scenario at expiry
Spot below 1.1970 : Buy EUR sell USD at 1.1970
Spot between 1.1970-1.2470 : Buy EUR in the market
Spot between 1.2470-1.3170 : Buy EUR at 1.2470
Spot between 1.3170 : Buy EUR at 1.24700, sell EUR at
1.3170, net receive 0.0700 USD per
1 EUR. Buy EUR from market for own
requirement
19
20. • Price tender at 1.2370
• If the bid is awarded
Keep the options as a hedge
• If the bid is lost
Sell of the option position to reduce expenditure.
There is potential for unlimited losses and gains
but less severe than forward
20
21. • Bidding in currencies other than cost currency give
rise to potential to loss or gain because of the
movement in FX rates
• Hedging the exposure before the bid to award date
may have cause unwanted positions in case the bid
is not awarded
• But a hedge is still required as not hedging can
result in less revenue
• Options offer flexibility and are better suited for
hedging such situations
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