Available Hedging Instruments

There is no “one size that fits all” when it comes to currency management. The most appropriate foreign exchange transaction will largely depend on your business requirements, the nature of the foreign exchange exposure (contracted or merely forecasted), and your appetite for risk.

The following sections provide a breakdown of the most commonly used instruments that are used for hedging purposes.

Vanilla Options

Available for digital booking via our platform or voice brokered
A vanilla option gives you the right (but not the obligation) to exchange one currency with another currency at a pre-agreed exchange rate on a specified date in the future.
By using a vanilla option, a business can protect 100% of its downside risk and benefit from any upside movements if the rate improves. Options are an extremely flexible instrument as it can be exercised early at no additional cost and there is no obligation to exercise the contract nor additional charges and penalties.

Vanilla Options
Cost Pros Cons

Unlike spot and forward contracts, spreads are not built into the exchange rate. Instead, an upfront protection fee (called a premium) is paid to purchase the contract. The premium is affected by the length of time, volatility in the currency pair and the protected exchange rate (called the strike rate).

  • No obligation means if the exchange rate improves you benefits
  • Limited downside and infinite upside
  • Extremely flexible
  • Many additional features as outlined below
  • Due to infinite upside potential and full downside protection, the cost of vanilla options can be relatively high in comparison to forwards
Additional features of Vanilla Options
  • Out-of-the-Money
    An out-of-the-money (OTM) option is when the strike rate (the protected exchange rate) is booked at a rate which is lower than the current market/spot/interbank rate. By lowering the strike rate, the protection cost (premium) reduces significantly.

    Example
    An option can be booked at a rate that is 5% lower than the current interbank rate. If the rate improves, you are free to trade at the better rate. If the rate moves against the you by 3%, there is no protection and you will take the loss. If, however, the rate moves 7% against you, you will only lose 5% as the protection kicks in at 5%.

  • Early Exercise
    Early exercise is exactly what it says – you can exercise an option on or any day before its expiry.
  • Cashing Out
    Cashing out takes place when a hedge has been booked and is no longer needed for whatever reason. You can sell the hedge back into the market and recoup some of the premium. It should be noted that the amount of time remaining on the hedge and the movements in the underlying currency pair will affect the cashing out amount you receive.

Spot FX

Currently voice brokered

A spot contract is the simplest form of currency exchange. It is where two parties agree to exchange one currency for another, with the settlement typically taking place within two days of the agreement.

Spot FX
Cost Pros Cons

FX Brokers and Banks will add a spread of anywhere between 0.2% to 4% to the interbank rate as a markup on the currency. Generally, the more currency you buy, the cheaper the fee charged.

  • Easy to access
  • Fast execution
  • Relatively cheap in cost
  • No exchange rate protection involved with spot transactions.

(Outright) FX Forwards

Currently voice brokered

A forward contract is an agreement to exchange one currency for another at an agreed upon rate on an agreed upon date in the future. Instead of using a forward contract, a business could choose to exchange one currency for another using a spot transaction and then hold the currency until needed. However, this may negatively affect the business’ cash flow and would require a foreign currency bank account to hold the funds. For these reasons some businesses prefer to use forward contracts.

Outright FX Forwards
Cost Pros Cons

FX Brokers and Banks will add a spread of anywhere between 0.2% and 4% to mark up the future-dated currency exchange.

  • Relatively easy to access
  • A future guaranteed exchange rate
  • 100% downside protection
  • Relatively low cost to purchase
  • Requires a margin deposit
  • You have an obligation to exchange at the guaranteed rate meaning they cannot benefit from upside movements in the exchange rate
  • Potential costs to cancel contract
  • Potential costs to exercise early or late

Non-Deliverable Forwards

Currently voice brokered

A non-deliverable forward (NDF) functions exactly like an outright forward, except no currency is exchanged on maturity. Rather, the trade is “cash settled” by one net profit/loss payment.

This type of transaction is perfect for situations where physical delivery of a currency is not possible. For example, when dealing in exotic currencies such as Ugandan Shilling, Indian Rupee, Indonesian Rupiah, Kenyan Shilling or Uruguayan Peso, setting up bank accounts to receive, send or hold currency is virtually impossible. Full protection however, is still possible through an NDF as there is no need to physically exchange the funds.

Non-Deliverable Forwards
Cost Pros Cons

NDFs are priced exactly like Outright Forwards – a spread is added to the future dated exchange rate.

  • 100% downside protection
  • Future guaranteed exchange rate
  • Ability to hedge exotic currencies without the need to find bank accounts
  • Ability to hedge assets that will not be converted at any point
    Example: a property owned overseas not expected to be sold, holdings in foreign stocks, etc.
  • Unable to participate in favourable movements
  • Contract cancellations or early draw-downs may result in additional costs
  • If NDF involves emerging market currencies, the markets are inherently less liquid and more exposed to fluctuations than major currency markets
  • A margin deposit is required

Participating Forwards

Currently voice brokered

A participating forward is an option strategy that involves securing a 100% downside hedge and allowing you to benefit, to some degree, on the potential upside of the trade.

This involves you buying a call or a put forward at a specific strike price and selling a call or a put forward at the same strike price but for a percentage of your notional amount, which caps the upside gain.

The participation level can be set anywhere between 1-99% (100% participation is a plain vanilla option). The two premiums can be offset to lower the premium cost or even make the strategy a zero-cost.

Participating Forwards
Cost Pros Cons

This structure can have a
zero-­cost, a cost built into the rate or even a fee instead – the cost largely depends on your preference.

  • The holder of the participating forward could potentially have no upfront premium
  • 100% protection against unfavourable currency moves
  • The holder can benefit from preferential rates up to their set percentage
  • Limits the participating forward’s ability to benefit from currency appreciation
  • The use of a forward contract could offer you a better rate
  • Termination of the contract could incur extra costs depending on the market rate at the time
  • A margin deposit is required

FX Collar

Currently voice brokered

An FX collar is an option strategy that involves buying a cap and selling a floor on the same currencies with the same expiration date.

This involves you buying a call or a put contract at a specific strike price and at the same time selling a call or a put contract at a different strike price which caps the upside gain.

FX Collar
Cost Pros Cons

The two contracts can be offset to lower the premium cost or even make the strategy a zero-cost.

  • The FX collar holder can manage foreign exchange risk and minimize the protection cost of hedging (potentially a zero-cost)
  • 100% protection against unfavourable currency moves
  • The holder can benefit from rates between the cap and the floor
  • Limits the FX Collar holder’s ability to benefit from currency appreciation
  • Using a forward contract could offer a better rate
  • Termination of the contracts could incur extra costs depending on the market rate at the time
  • A margin deposit is required