4-minute read
If you're familiar with the world of currency trading, you've probably come across the term "leverage". IG, the world's largest provider of forex CFDs, define leverage as "a concept that can enable you to multiply your exposure to a financial market without committing extra investment capital."
But we're not here to talk about leverage in terms of investments or properly speculative trading; this article is about leverage in business currency hedging.
In this blog post, we'll explore what leverage is, how it works through the lens of currency hedging for businesses, and you can decide whether it's worth the risk!
Understanding Leverage
A common foreign exchange hedging instrument that does not include leverage is the humble forward contract. A forward is an agreement to exchange one currency for another, at an agreed exchange rate, on an agreed future date. Simple.
We can synthesise a forward contract by using FX Options: A put (call) option is bought concurrently with the sale of a call (put) option. Both options have the same strike rate, expiry date, and notional amount, meaning regardless of whether the market rises or falls, the resultant position is the same as a forward contract – the buyer of the product (the hedging business) has a fixed exchange rate.
👉 An option is a financial instrument which gives the buyer the right but not the obligation to exchange one currency for another. In this regard, it's similar to an insurance product whereby the buyer would only use it ('exercise' the option) if it was in their interests to do so.
How do we make a synthetic forward contract?
It's painfully straightforward. In my example above, there is one option that is being purchased and one that is being sold. This is important for the following reasons:
The option that is bought...
- Is the hedger's protection against unfavourable rate movements
- Requires a premium to be paid to purchase it
- Can only have a positive mark-to-market for the hedger
The option that is sold...
- Gives the hedger an obligation to exchange at the strike rate (equal to the forward rate in this example) in the event of an otherwise favourable market movement
- Pays a premium to its seller (the hedger), which will net with the premium paid on the bought option to produce zero at the forward rate
- Can only have a negative mark-to-market for the hedger
Are you still with me? Let's use an example to bring this to life a bit. If a UK importer is buying widgets from the USA in dollars, this is how to create a synthetic forward using options:
- Purchase a GBP Put option: if the spot rate ends below the strike rate, the hedger exercises their option and is protected against the unfavourable movement. Conversely, if the spot rate ends above the strike rate, this option is worthless.
- Sell a GBP Call option: if the spot rate ends below the strike rate, this option is worthless and is not exercised. Conversely, if the spot rate ends above the strike rate, this option is in-the-money to the buyer (bank/broker), and is exercised against the hedger, meaning they are obligated to sell GBP and buy USD at the strike rate, which is obviously worse than the prevailing spot rate.
Come on, where's the leverage bit?
Leverage in this context refers to a situation whereby the hedger's potential obligated amount (the liability) is greater than their protected amount. So, let's say our UK business bought protection for say, $100,000, in a leveraged forward, the potential obligation might be say, $150,000 or $200,000.
The notional amount on the sold option is greater than that of the bought option.
What's the point in doing this?
Remember I said that buying options costs (premium), but selling options pays? If you increase the notional amount on the options you're selling, you will generate more premium – you are making a net credit from the outset. This means that, if you trade a leveraged forward at the forward rate, you will be paid to do so.
But that's not the typical setup at all. Usually what happens is the extra premium generated (by selling more options than are being bought) is used to fund the purchase of protective options at rates that are better-than the forward rate.
So, by adding leverage to the equation, the strike rate on the product can be made better-than the equivalent forward. The product still acts like a forward in that there's one rate to think about, it's just the potential outcomes are now different...
Let's go back to my UK importer example to explain what now happens, if they were to buy a leveraged forward to protect $100,000 with a 1:2 leverage ratio:
- Spot ends below the strike: hedger buys $100,000 at the strike
- Spot ends above the strike: hedger buys $200,000 at the strike
The strike rate would be better than the forward rate, so if the market only falls then they're better off, but in the event of the market rising, they're worse-off.
If you're looking at those two bullet points and thinking "this isn't a hedge", then you're right. The business can only ever be 50% hedged (under-hedged) or 100% over-hedged, right? Yes. Simple. There's not much else to it.
The hedger may well have either too much or too few funds when it comes to the contract expiry date. Of course, if they need $100k, and protect $100k, they could be fortunate if the market moves unfavourably and they are fully protected, but if the market were to move favourably then they would end up with funds they don't need. These additional funds could be sold for a loss, or rolled forward for future use.
Leverage can be added to basically any structured option contract as a means of funding enhanced strike rates or other path-dependent features.
Anybody considering leveraged foreign exchange contracts should be acutely aware of the potential losses vs the potential gains – these should be spelled out clearly, with numbers, charts, and tables.
Conclusion
In conclusion, leveraged FX contracts can indeed offer opportunities for enhanced outcomes in business currency hedging. However, it's imperative to approach this strategy with a clear understanding of the associated risks and potential rewards.
While leverage can improve strike rates, it also introduces complexities, potential financial losses, and path-dependent outcomes that demand careful navigation.
Before diving into leveraged foreign exchange contracts, it's essential to conduct thorough analysis, assess the numbers, and consider the implications for your business's financial well-being.
If you would like some experienced guidance on how best to manage your business' currency risk, speak to us today.
We Can Help You
We'd be very happy to support you in identifying your currency risks, deciding on the most critical risks to manage and how, and providing a framework and trading facilities to get on with it...
Oku Markets is a full-service consultant and FX business covering all the products named above and with years of experience in advising businesses on their FX risk. Drop us a line on 0203 838 0250 or info@okumarkets.com
Frequently Asked Questions
- What exactly is leverage in the context of business currency hedging?Leverage in currency hedging refers to amplifying potential obligations beyond protection through structured option contracts. It allows businesses to enhance their positions and improve strike rates by selling options with higher notional values to generate additional premium.
- How does a synthetic forward contract differ from a traditional forward contract?A synthetic forward contract replicates the outcome of a traditional forward contract using a combination of FX Options. By buying one option and selling another with identical terms (same strike rate, expiration date, and notional value), businesses create a position akin to a forward contract, providing protection against adverse currency movements.
- What are the benefits of using leverage in currency hedging?Leveraging structured option contracts can offer several benefits, including enhanced strike rates and upfront premium generation through selling options. This surplus premium can then be used to finance protective options at superior rates than the forward rate, potentially providing better outcomes.
- What are the potential drawbacks or risks associated with leveraging currency hedging contracts?While leverage can boost potential gains, it also introduces complexities and risks. Leveraged contracts may lead to over-hedging or under-hedging, resulting in surplus or shortfall when the contract matures. Additionally, a rising market could leave businesses worse off, despite the improved strike rates, resulting in financial losses.
- How should businesses approach leveraging foreign exchange contracts responsibly?Businesses should approach leveraging foreign exchange contracts with caution and careful consideration. Conduct thorough analysis, assess the numbers, and understand the implications for the business's financial well-being before venturing into leveraged currency hedging. It's crucial to have a clear understanding of the associated risks and potential rewards to make informed decisions.
