Protection option

A protection option is another form of foreign exchange hedging. Like a forward contract, it lets you set a worst case rate. 

Unlike a forward contract you pay a fee up front called a premium. This premium gives you the right rather than the obligation to buy at this worst case rate. 

If the rate moves against you, you just use your worst case rate. However, if exchange rates move in your favour, you can use the improved spot rate. 

Advantages

• You get all the benefits of a forward contract
• Guaranteed worst case rate
• You benefit 100% if the rate moves in your favour

Disadvantages

• Upfront premium (cost)

How this works for an importer

Let’s say that the forward contract rate is 1.23. You set your worst case rate at 1.23, and you pay a 2% premium.

Scenario 1 – On expiry, the spot rate is below 1.23 

You buy your euros at 1.23

Scenario 2 – On expiry, the spot rate is above 1.23

You buy your euros at the higher spot rate 

How this works for an exporter 

Let’s say that the forward contract rate is 1.23. You set your worst case rate at 1.23, and you pay a 2% premium.

Scenario 1 – On expiry, the spot rate is above 1.23 

You sell your euros at 1.23

Scenario 2 – On expiry, the spot rate is below 1.23

You sell your euros at the lower spot rate

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