29 November 2012

Hedging Basics: FX Hedging Using a Currency Put

Learn about one of the easiest and most effective ways to hedge a currency position, by purchasing a protective currency put.

Currency hedging is a financial exercise in which a treasurer will mitigate their exposure to directional currency movements in an effort to smooth returns or stabilize cash flows. One of the easiest and most effective ways to hedge a currency position is to purchase a protective currency put, which will offset any losses below a specific strike price.

Put Option Basics
A currency pair put, is the right but not the obligation to sell a designated currency pair at a specific strike, on or before a certain date.  The exchange rate that the parties that transact a currency put is referred to as the strike price, while the date when the option expires is called the expiration date.  European style currency options allow the owner of a put to exercise the put only on the expiration date while American style options allow the flexibility to exercise the option on or before the expiration date.

The Payout of a Currency Put
The payout a currency hedger receives from the purchase of a put is the difference between the spot market of a currency and the strike price of the option at the time the option is exercised.  Options can be settled on a physical basis, where actual currency changes hands at the strike price exchange rate or on a cash basis where one party makes a payment to its counterparty.

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