Myths That Aren't

Christopher S. Bourdain, a corporate currency risk management specialist at Chase Manhattan Bank, responds to an article by NYU professor Ian Giddy in our February issue.

In his "Six Common Myths About FX Options," Professor Ian Giddy discusses so called "common myths" that are used to promote corporate use of FX options. He then takes issue with these six "myths," largely in an attempt to demonstrate that for corporations "the range of truly non-speculative uses for currency options...is quite small." I will attempt to show the error in some of Professor Giddy's assertions.

"Myth" One:

"Writing covered options is safe, and can earn money, as long as the company has the underlying currency to deliver."

Believe it or not, this "myth" is 100 percent true! At least covered writing does not increase risk if one already has the underlying position. The key point here is that writing options never constitutes a hedge as it offers no protection against downside risk. At best, it caps out one's upside potential on an underlying position beyond the chosen option "strike" level-exactly as a forward contract would.

Giddy shows how a long-yen/ short-yen call position equates to being short a "naked" yen put when looked at in isolation: in either instance, the optimal payout (maximum receipt of dollars) occurs if the yen remains steady or strengthens, while an adverse outcome (fewer dollars received) occurs with a yen decline.

However, Giddy's belief that "covered option writing is just as risky as naked option writing" applies only if the underlying currency position is speculative to start with, i.e. created purely for the purposes of trading gain. It is not fair at all to say that "the covered option writer is a sheer speculator too" about corporations whose currency positions are generated by ongoing foreign sales or investments, since it is no more risky nor any more or less speculative than choosing to remain unhedged. Indeed, writing covered options can be an appropriate strategy for a corporation which has already consciously chosen to remain unhedged on certain exposures, and which secondarily might elect to "cap out" its upside to generate premium income.

In any case, in the "real world," it is rare to see large U.S. corporations writing covered options in isolation without addressing their downside risk in some way. Much more typically, they will only write options to help defray the cost of purchasing some other options, which provide the true hedge.

"Myth" Two:

"Buying puts or calls to hedge a known foreign currency exposure offers upside potential without the risk of speculating on the currency."

This "myth" is also true. Giddy shows how in isolation, a long-currency/long-put position equates to a long-call position, because the optimal payout either way occurs when the currency strengthens. Yet he strangely argues that a corporation which is long currency from a business operation is a "speculator" when it buys puts to retain the ability to benefit from a declining dollar while securing against a dollar rally. Implicitly the professor seems to suggest that it is "speculative" for a corporation to sell outside its home country because doing so creates currency positions.

To me a worse dereliction of fiduciary duty would occur if a corporation believes that rates are likely to improve and that FX option premium levels are cheap relative to the upside, but then nonetheless puts on a forward contract to hedge a currency exposure. Such use of forwards implies a contrary belief, i.e. that current rates are optimal, and runs the risk of locking the user into obligations to settle at what could end up being unattractive rates. If we compare the payout graphs of options versus forwards, I would argue that eliminating the downward half of the picture beyond the premium cost while retaining the upward half is indeed a reduction of risk and is therefore almost always an alternative worth considering.

"Myth" Three:

"Options are a great hedge against accounting exposure."

This surely is not really a "common" myth, since there is in fact no "great" hedge against earnings or balance sheet translation risk. The very concept of hedging such risk is the subject of ongoing debate, because any class of hedge instrument ultimately leaves the user at risk of putting out cash against a non-cash exposure. U.S. corporations that do choose to hedge such exposures tend to be those for whom non-dollar earnings and/or assets represent more than 40 percent of the total. For such firms swings in currency values can have a material impact on their reported financial condition.

As Giddy states, using forwards to hedge accounting risk "can produce real cash losses that can be hard to justify." Because of this, some firms have found options to be a more palatable means to hedge such risk. Using options they can continue to bear some degree of translation risk acceptable to them by choosing an out-of-the-money strike price, while protecting against further deterioration in translated income or net assets beyond some chosen "worst-case" level-all at a known maximum cash cost (the premium). Giddy's final remark here, that an "open, unmanaged option's position can add to the variability of cash flows," is off the mark, since by definition the cash cost of a standard option is known up front and limited.

"Myth" Four:

"Options offer a useful way to hedge foreign currency exposures without the risk of reporting derivative exposures."

Real losses on a purchased option can never exceed the premium paid, but a big rise and subsequent fall in an option's value over different reporting periods could create large apparent losses on a corporation's books, depending on the accounting treatment. It is true that when corporations are looking to hedge certain types of non-transactional exposures, the accounting treatment for options can sometimes carry advantages versus the treatment of forward contracts. However, if used to hedge an economic exposure such as Giddy describes, options would in fact be subject to mark-to-market accounting, and would have to be reported as derivative exposures.

"Myth" Five:

"Selling an option is better than using forwards or swaps when the counterparty is risky, because the option buyer cannot default."

In a vacuum, it is true that an option seller has no mark-to-market risk exposure to the buyer, because the buyer would only exercise at maturity if the option is at a gain. (An option buyer can still default on settlement, but this risk can be addressed with various "netting agreements.) However, I have never heard anyone make this supposedly "common" argument to generate corporate business, because selling options does not provide a hedge against downside risk.

In the real world, corporations typically write and buy options simultaneously, their prime aim being to cover downside risk, and they favor the convenience of dealing where they can get both done. Pricing works out better this way as well: a buy/sell "combo" bears less inherent risk for a bank than doing a single option, so banks invariably put better pricing on such "combos." Corporations that have credit concerns about a bank will simply avoid dealing with them at all.

"Myth" Six:

"Currency options offer the ideal way to hedge uncertain exposures such as contract bids."

Giddy makes a strange argument against this statement, suggesting that it is somehow bad to use an option to hedge a contract bid because its "value will continue to fluctuate even after the outcome of the bid is known," and that this is "risky." The riskiness argument is a false one, because the maximum potential loss on an option (the premium) is known and prepaid.

To be sure, it could happen that a corporation loses a contract bid but ends up with a gain on an option that is no longer needed as a hedge. However, surely an occasional windfall in this scenario is better than the substantial loss a corporation could incur if: 1) it wins the contract but loses money being unhedged against the currency risk, or 2) it loses the contract but loses money being locked into a forward FX contract at a bad rate. My own view is that the more uncertain a potential future cash flow, the stronger will be the argument for using options if one wishes to hedge such risk (the most common alternative being to remain unhedged).

Conclusion:

Professor Giddy seems to believe that corporate use of FX options is generally "speculative" and therefore bad, and that only forwards are a viable means of hedging FX exposures. He also seems to believe that accounting translation risk is somehow fictitious and less needful of hedging.

I would argue that remaining unhedged or using forwards can in fact be more speculative than purchasing options, as the former implies speculation that rates will improve, while the latter implies speculation that rates are already at their optimal levels. Both entail the risk of substantial real loss (in the first instance) or substantial loss of opportunity, competitive advantage or cash outlay (in the second instance).

Purchase of options implies a more limited speculation, i.e. that future rate moves will exceed the option's upfront price and thereby justify the expenditure involved in maintaining the upside potential-which is the true value of an option relative to a forward. Meanwhile, writing covered options does not increase risk in any way versus remaining unhedged, but rather only caps out potential future advantage exactly as would a forward contract.

Giddy is correct in suggesting that many option users need to better understand how options can alter a financial risk profile, and under what circumstances options can be an appropriate solution in their particular hedging programs and possibly add to shareholder value. However, by ringing alarms where none need to be rung, Professor Giddy does a disservice both to users and to providers of these valuable financial risk management tools.