Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.
Suppose a Philippine manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the PHP strengthens against the US$ over the next 90 days the Philippine firm will lose money, as it will receive less PHP when the US$100,000 is converted into PHP. However, if the PHP weaken against the US$, then the Philippine firm will gain additional money: the firm is exposed to FX risk.
Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for PHP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm’s exposure, perfectly hedging their FX risk.
If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.
Using options, the Philippine firm can purchase a PHP call/USD put option (the right to sell part or all of their expected income for peso at a predetermined rate), which will:
- protect the PHP value that the firm will receive in 90 day’s time (presuming the cash is received)
- cost at most the option premium (unlike a forward, which can have unlimited losses)
- yield a profit if the expected cash is not received but FX rates move in its favor
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