In the previous piece in our options series, we discussed the general characteristics of exotic forex option structures and their role in an FX risk management strategy. Here, we look at how businesses can use exotic options to reduce their hedging costs as part of a well-considered FX risk management strategy.

This article assumes familiarity with how options work, and option terminology is used throughout. Readers who are unfamiliar with options may wish to review the first article in this series before reading further.

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In some types of options, the premium is reduced or eliminated because the structure of the contract enables the seller to share in the benefits of favorable exchange rate movements.

We can regard this as a combination of a vanilla call option and an outright currency forward contract at the protection rate. Because only part of the contract is at a fixed rate, FX losses due to a business being unable to take advantage of favorable exchange rate movements are likely to be lower than they would be from hedging entirely with a forward contract.

Alternatively, a collar can be viewed as an option combination: The strike price of the purchased option is the protection rate and the strike price of the written option is the participation rate. The exporter wishes to avoid losses in Australian dollars should the AUD-USD exchange rate rise in that time.

Barrier Option

But he would rather accept less benefit if the AUD-USD exchange rate falls than pay a premium for a vanilla put option which he would lose if the option expired out-of-the-money. So he buys an AUD-USD call option with a strike price of 0. This structure is a collar: But if the AUD-USD exchange rate falls to 0.

There is no premium for the AUD call, so if it expires out-of-the-money the company has lost nothing.

Barrier Option

But if the AUD-USD exchange rate drops enough to trigger the AUD put, the company will lose the difference between the spot price and the participation rate.

Collars can be effective low-cost hedges if the currency is relatively stable, but if the currency is volatile, holders of collars may potentially incur large notional losses from favorable exchange rate moves.

Another way of reducing the premium cost while maintaining an effective hedge is to set conditions for the activation of the option. Barrier options are one way of doing this.

There are two basic types of barrier options:. Note that these options are always European options, american single barrier option investopedia the flexible exercise date of an American option is not compatible with knock-in or knock-out triggers. In backtesting options strategies thinkorswim context of the earlier collar example, instead of buying an AUD-USD collar with protection rate 0.

If the AUD-USD exchange rate rises to 0. But what happens should the exchange rate fall is more complicated. The call option expires out-of-the-money, but there are two alternatives for the put option:. Thus, using a barrier option instead of a simple collar can enable a company to eliminate the option premium while limiting notional losses from favorable exchange rate moves.

Barrier options can be single or double trigger. In a double trigger, a trigger rate is set on both sides of the structure. So, for example, in our example above, a cost-conscious company could set making money with blogging sites up-and-in trigger at 0.

Neither option would activate until one or the other of the triggers is reached. Such a structure would not eliminate all FX risk, but would provide low-cost protection against unexpected currency volatility. But for some businesses they can provide effective FX hedging at lower cost than simple forward contracts and vanilla forex options. With 17 years experience in the financial industry, Frances is a highly regarded writer capital gains and stock options speaker on banking, finance and economics.

She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV. Exotic Options and Hybrids: Article s on this website that are identified as being prepared by third parties are made available to you for information purposes only.

These third party articles do not represent the opinions, views or analysis of American Express and American Express does not make any representations as to their accuracy or completeness. If you have questions about the matters discussed in those articles, please consult your own legal, tax and financial advisors.

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Industry Solutions Financial Institutions. Using Exotic Forex Options to Reduce Hedging Costs in FX Risk Management Strategy ARTICLE By Frances Coppola.

Frances Coppola With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. Related Links International Payments for Business Business Payment Methods and Solutions Frequently Asked Questions.

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