Chapter 15 • International aspects of business finance
the obligation, to exchange a specified amount of a particular currency for another
one, at a rate and at a time specified in the option contract. For example, a business
expecting to receive a sum in a foreign currency in three months’ time could buy an
option to exchange the specified amount of foreign currency for the home currency in
three months’ time at a specified rate. This would be known as a ‘put’ option because
it enables the holder to sell the foreign currency.
Note, particularly, that the owner of the option has the right to sell the currency to
the grantor of the option, but does not have to do so. If the foreign currency has
strengthened against the home one during the three months, the option holder would
ignore the option and sell the currency in the spot market when it is received.
Similarly, if the customer defaults, the option is ignored. The option acts rather like an
insurance policy. The business is prepared to pay to buy the option because, if the
worst happens and the foreign currency weakens against the home one, it can exercise
its option. If all goes well the option will simply lapse.
It is equally possible to buy a ‘call’ option, that is, the right to buy a specified amount
of a foreign currency, at a specified rate to the home currency, at a specified time in the
future. A business expecting to pay a bill denominated in a foreign currency might
choose to avoid transaction risk by using a call option in the currency concerned.
The disadvantage of using foreign exchange options to avoid transaction risk is the
cost. The grantor of the option does not have the right to insist that the business exer-
cises the option. The option will be exercised only if the exchange rate movement is
disadvantageous from the grantor’s point of view. The grantor will therefore need a
good incentive to be prepared to grant a particular option.
The Ricci and Di Nino (2000) survey showed options to be a popular means of deal-
ing with exchange rate risk, with 75 per cent of respondents using them, at least some
of the time.Currency futures
Currency futurescontracts are quite like forward contracts in that they bind the par-
ties to the exchange of two amounts, at exchange rates and at a future date all specified
in the contract. Where futures differ from forwards is that they exist only for ex-
changes between relatively few currencies, relatively few values and relatively few
future points in time, in other words they are standardised contracts.
These restrictions tend to make futures unwieldy in that it may not be possible to
hedge a particular exchange rate risk exactly because the standard values and matur-
ity dates may not precisely match the needs of the business. On the other hand, the
standardised nature of futures means they can be bought and sold, and there is a mar-
ket for currency futures. This means that businesses can create a hedge without hav-
ing to identify a counterparty: they can simply buy a futures contract in the market.
Similarly, a futures contract that is no longer required can be sold.
The Ricci and Di Nino (2000) survey indicates that futures are not a very popular
approach to dealing with exchange rate risk.
Futures, forward contracts and options are all examples of financial derivatives that
can be used to reduce or eliminate risk.Economic risk
The problem
When a business’s fortunes are capable of being affected by movements in exchange
rates, the business is said to be exposed to economic risk.Some people see transaction‘
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