The Protection Option

For Importers

The protection option provides clients with the right to buy a currency on a pre-determined forward date at a pre-determined rate. However, at expiry, the client can elect not to exercise the protection option and buy in the spot market if the spot rate is more advantageous. The protection option combines the certain protection provided by a forward contract and the flexibility of being able to leave an exposure unhedged. A premium is payable for a protection option.

How does a protection option work?

For example, let's assume a client imports furniture from the US, and needs to buy US$1 million in six months' time to pay a supplier.

The forward rate for six months is 0.6800 and the client doesn't want to get a worse rate than 0.6800.However, the client thinks that the Australian dollar is going to strengthen further against the US dollar.The client would purchase a protection option at 0.6800 maturing in six months' time. A premium of $30,000 would be payable to World First for the protection option.

Possible scenarios:

Scenario 1: AUD/USD weakens and at maturity the exchange rate is 0.62.

The client would simply exercise the protection option and buy the US dollars at 0.6800

Scenario 2: AUD/USD strengthens and at maturity the exchange rate is 0.7400.

The client simply transacts in the spot market and achieves a rate of 0.7400

Advantages

Certainty of a worst case rate

The client has 100% protection if the rate moves against him

The client has 100% flexibility if the rate moves with him

Disadvantages

An upfront premium is payable (in this example 3% of the notional = $30,000)

If the spot rate at expiry is above 0.68, he will not use the option and would have been better off remaining un-hedged.

For Exporters

The protection option provides clients with the right to sell a currency on a pre-determined forward date at a pre-determined rate. However, clients can elect not to exercise their protection option and sell the currency in the spot market if the spot rate is more advantageous. The protection option combines the certain protection provided by a forward contract and the flexibility of being able to leave an exposure unhedged. A premium is payable for a protection option.

How does a protection option work?

For example, let's assume a client exports widgets to the US, and she forecasts that she will need to repatriate US dollar proceeds of US$1 million in six months' time.

The forward rate for six months is 0.6800 and the client doesn't want to get a higher rate than 0.6800. However, the client thinks that the Australian dollar is going to weaken further against the US dollar. She would purchase a protection option at 0.6800 maturing in six months' time. A premium of $30,000 would be payable to World First for the protection option.

Possible scenarios:

Scenario 1: AUD/USD strengthens and at maturity the exchange rate is 0.7400.

The client would simply exercise the protection option and sell the dollars at 0.6800

Scenario 2: AUD/USD weakens and at maturity the exchange rate is 0.6000.

The client simply deals in the spot market and achieves a rate of 0.6000

Clients can build the premium cost into the hedge rate to find their effective hedge rate or break even point. For example, if the exchange rate is trading at 0.6000 two days before settlement, the effective hedge rate will be 0.6000 plus the initial premium cost of $30,000, which would move the effective hedge rate up to 0.6200.

Advantages

Certainty of a worst case rate

The client has 100% protection if the rate moves against her

The client has 100% flexibility if the rate moves with her

Disadvantages

An upfront premium is payable (in this example 3% of the notional = $30,000)

If the spot rate at expiry is below 0.68, she will not use the option and would have been better off remaining un-hedged.

World First Pty Ltd holds an Australian Financial Services Licence - Licence No: 331945 -under the Corporations Act 2001 which authorises it to provide financial services in relation to foreign exchange contracts, derivatives and non cash payments facilities to persons within Australia.

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