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The ‘Paradox of Risk’ p.1

You’re the CFO of a medium-sized firm, and you want to provide your firm with the best possible strategy to deal with currency risks. You may have dealt with these risks on a smaller scale before. And it’s likely that you took what you thought was a risk averse stance, and thus paid all overseas invoices at the Spot rate. You traded at Spot because you felt that Forward Exchange Contracts and Options were risky and you had heard of companies that had been burnt using them.
However, by choosing to pay all of your invoices at the Spot rate, a little red flag popped up in the back of your mind warned you that this may not truly be the safest strategy…  this is the ‘Paradox of Risk’. 
Allow me to explain…
If you trade at Spot, you are trading at today’s rate (let’s assume 103c). If you receive an invoice that asks you to pay USD in 60 days and you decide to wait till the due date, you have just taken on 60 days of risk. There are now two months in which the exchange rate is able to move in either direction. And given that we can move more than a couple of percent overnight, the risk could actually be quite large over a two month period.
You have already priced this stock to your clients in Aussie Dollars. However, you don’t know exactly what price you will be paying for this stock (in Aussie dollars) because the currency rate is always moving. Now let’s assume that the AUDUSD rate declines by 12c in that time (which is a conservative fall). Now you’ve just realised a loss of around 12% just on that invoice alone.
So what is the alternative?
Well, let’s road test the once feared Forward Exchange Contracts (FEC) to see how they stack up, using the same example. Instead of waiting 60 days, we simply lock in a Forward at 99c. The market still loses 12c, however we are protected and end up paying for the stock at 99c. We have also spent 60 days without worrying whether the exchange rate would fall, and we have the peace of mind that we have locked in a considerable profit on that particular shipment. Beautiful.
It’s the perfect strategy, right? Not necessarily… Let me explain.
We’ll assume that on your next shipment you follow exactyly the same strategy, but this by the time lock in a Forward the rate is down 90c. On this occasion the market moves back up to 105c over the next two months. You have still locked in a your profit on the shipment and this should instill the same ‘peace of mind’ as the previous example. However, there’s a board meeting tomorrow and you have to explain to the board why you’re paying an invoice at 90c rather that the current 105c. Dang!
Have I confused the issue? I started by proposing that trading at Spot was risky, now I’m proving how Forwards can be risky as well. In actual fact I’m not trying to prove anything at this stage, except to illustrate that both Spot and Forwards can be risky in different ways. So what can a CFO do if this is the case?
What are your Options?
Let me now introduce Options into the conversation. Just the word ‘Option’ raises concern to most business owners and CFO’s. We’ve all heard horror stories of how option strategies have gone horribly wrong, and most of these may well be true. Options can be used dangerously and speculatively to make money in volatile markets and in quiet markets. But Options can also be safely used as a hedging strategy. I suppose you can think about Options as being Forwards on steroids.
Why? Options can provide 100% protection to your worst case rate in a similar way to a Forward, with the added advantage of upside. Yes, that’s right. If the market moves to 105c you can now take advantage of the enhanced rate (assuming a well planned options strategy (and not all options strategies are alike)).
Let’s road test this, using the two previous examples. Let’s hedge our invoice using today’s spot rate of 103c by locking in a worst case rate of 98c (100% protection) with a portfolio of options. The market moves to 90c and yet we are able to pay our invoices at 98c!!! We are 8 cents better off by using an options strategy here. The next invoice (as per previous example) we again lock in protection at 88c with a portfolio of options. Thereafter the market moves to 105c. We can now pay this invoice at above 105 cents! In this case, we are no longer worried about the concept of an opportunity loss.
So not only can we lock in 100% protection, we can also take advantage of upward rate movements. Let me put this another way… Not only can we now trade at the Spot rate when we want to, we can also trade at close to the Forward rate when the market turns against us. Brilliant!
A further benefit could be in smoothing out the equity curve. Look at the Diagram below to compare a company with spot only payments to that with a prudent options strategy. You’ll notice that the equity curve (if marked-to-market each day) moves exactly with the movements of the currency rate movements. When you apply an options strategy you will notice the equity curve becomes a lot more predictable. On each shipment of goods you should be locking in profit, with the possibility of cream on top. The only real unknown when you use options properly should be how big a profit you will take. That’s not a bad problem to have.

A smoother equity curve means better sleep at night! 

So what is this ‘The Paradox of Risk’? 
I suppose to summarise the ‘paradox’ here is that while most importers believe that paying their invoices at Spot is safe, it is possibly the exact opposite.

At the other end of the scale, Options have a stigmatic name due to those who have used them as speculative tool and been burnt accordingly. However they can in fact be used as a safe measure for hedging, and allowing 100% upside potential to boot. So does this mean we’ve found the perfect strategy?
Maybe, maybe not. It’s not quite that simple. Next issue we discover when and where Options can be the answer…
By Marcus Addison

Posted on December 17, 2012

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