Forex management tools handy hedge

Press, 11 July 1988, Page 27

Forex management tools handy hedge

By

MARK REYNOLDS

Since the New Zealand dollar was floated on March 4, 1985, foreign exchange management has become an integral part of running an importing or exporting business.

In that time the kiwi dollar has revalued by nearly 60 per cent against the United States dollar, bringing many well publicised cries of anguish from exporters. But such gnashing of teeth could have been avoided through the use of one of the wide range of foreign exchange management tools which have become available in the last three years. One such package, not widely used in New Zealand at present, is the currency option. The option is basically an insurance cover on foreign exchange exposure.

If the exchange rate for the New Zealand dollar moves out of favour then the insurance is called upon — similar to using an insurance policy to repair your car after a crash.

A more precise definition is that a currency option gives the holder the right, but not the obligation, to buy or sell a fixed amount of currency at an agreed rate of exchange, on a specific date. For this right a premium is paid. Like all insurance policies, the premium varies in accordance with the size and duration of the risk.

The Development Finance Corporation’s corporate dealer in Christchurch, Ms Jane Huria, said the option takes traditional foreign

exchange contracts a step further in that they offer a hedge but no outright commitment.

For example, a New Zealand exporter looking to bring United States earnings back into New Zealand could take out a currency option with a contract rate of US66c, expiring on September 12. This would give the holder the right to sell US dollars and buy New Zealand dollars at a rate of US66c on that date.

If, on September 12, the New Zealand dollar exchange rate is below US66c (for example US63c), the holder would not exercise the option — it would be cheaper to buy New Zealand dollars at the current market rate, Ms Huria said. However, if the exchange rate for the kiwi is above US66c (for example US69c), the holder would exercise the option to buy New Zealand dollars at US66c. On SNZIOO,OOO, this would effectively save SUS3OOO. The situation is reversed for a New Zealand exporter. "Currency options provide protection against adverse exchange rates, without locking in a rate that may eventually prove unprofitable,” Ms Huria said.

If the option is not exercised, the premium is forfeited — as is the case with car insurance.

The premium is calculated taking many factors into account. One such factor is the exercise price. The less favourable the strike price for the option buyer, the lower the premium. For example,

with the US dollar at US66c the right to exchange NZ dollars at a strike price of US67c would be less than the right to exchange them at US65c. Another determinant for the premium is the expected volatility of the exchange rate of the underlying currency over the life of the option. This is perhaps the most important factor influencing the premium. Because the option holder is protecting himself against future changes in the exchange rate, the higher the volatility of a currency, the higher the premium. For example, the premium payable on an options contract to exchange Australian dollars for New Zealand dollars would be more than the premium to exchange the more stable Japanese yen for kiwi.

The concept of options is not new. Options in commodities have been traded for centuries, but the markets were disorganised and transactions were both difficult to arrange and expensive to complete. In the early 1970 s investment companies began focusing on stock options as an additional tool for their investment protection.

Currency options followed in the 1980 s, predominantly in North America and Europe. But options quoted were on major currencies — not on a currency minnow like the New Zealand dollar.

The great benefit that currency options have over existing financial

tools for foreign exchange management is that the worst cost is known at the beginning of the contract.

Should rates move strongly against the hedge, the most lost is the premium paid. But if the exchange rate moves in a favourable direction, gains are unlimited.

For this reason currency options should not be confused with leveraged currency contracts. These offer unlimited opportunities for foreign exchange gains or losses, but are normally subject to margin calls should the currency being hedged move out of favour. Since March, 1985, the average monthly range of the New Zealand/US dollar exchange rate has been about 6 per cent. The quarterly range has averaged about 12 per cent, fluctuating between 5.8 per cent and 23.4 per cent. Large ranges have also occurred on some New Zealand dollar cross rates, such as the NZ/ Australian and the SNZ/ yen.

A typical one month option only costs between 1.2 per cent and 2 per cent for the premium. A typical three month option premium is between 2 per cent and 3 per cent. Given the volatility of the New Zealand dollar, currency options offer a reasonably priced hedging method.

Perhaps the best competition for currency options will come when the New Zealand Futures Exchange offers options on its soon-to-be-quoted Kiwi dollar contract. These should be offered before the end of the year.