FX Volatility: Is it the right time to practice Dynamic Hedging?

FX Volatility: Is it the right time to practice Dynamic Hedging?

29 Jun 2020 05:35 PM
 

What is Dynamic Hedging?

Dynamic hedging is a foreign exchange risk management strategy that allows businesses and individuals to readapt their hedging positions to evolving market conditions by providing flexible solutions to protect investments from exchange rate risks.

As the FX markets evolve, this strategy allows the hedging rates to correspondingly readapt. Thus, international businesses exposed to FX volatility can hedge their exposures at rates that are closer to current exchange rates.

Exotic FX Options: Tool for Dynamic Hedging

Exotic options are different from plain vanilla options in terms of how payoff is determined and when the option can be exercised. These are more complex and usually trade in the over-the-counter (OTC) market.

Despite their complexities Exotic options are a great tool for dynamic hedging as they are customizable to specific risk-management needs of the investor- risk tolerance, profit requirement. Also, they have lower premium than the more flexible American options.

Types of Exotic options that can be used for dynamic hedging in forex risk management include the following:

  • Chooser Option: It allows the investor to choose whether the option is put or call at a certain point in option’s life. This can be used when sudden news arrives such as event release, political upheaval, etc, that can influence the exchange rate movement.
  • Compound Option: It gives the right, not the obligation, to buy an option at a specific price on a predetermined future date. In other words, the underlying in a compound option is an option contract. Four types of compound options are: call on call, put on put, call on put and, put on call.
  • Barrier Options: These are similar to plain vanilla options but only get knocked-in (activated) or knocked-out (extinguished) when the exchange rate hits a preset level. Four types of barrier options are:

Up and out: when exchange rate rises and knocks out the option

Down and out: When exchange rate falls and knocks out the option

Up and in: When exchange rate rises and knocks in the option

Down and in: When exchange rate falls and knocks in the option

There are many more types of Exotic FX options which can be used to dynamically hedge the currency risk. Some may cost higher than traditional options because of attractive additional features. While some of them may also cost lower as the additional features may increase their probability to expire worthless. These unique features of exotic options, makes them a good-fit for high level active portfolio management and situation-specific solutions.

Benefits

  • Help preserve profit margins

In comparison to static hedge, dynamic hedge helps businesses, dealing in international markets, preserve their profit margins. Let us suppose that an exporter, who is selling goods overseas in foreign currencies, is facing continuous exposure to exchange rate fluctuations. Now, he has two options:

  1. Hedge-in-advance: The exporter hedges in advance their estimated sales volume, after setting their product prices according to a target exchange rate, for a defined period of time that might be a few months or an year. This strategy promises steady margin but if the exchange rate fluctuates, it might be difficult to readapt the prices and can lead to loss of competitiveness.
  2. Dynamic Hedge: The exporter hedges the accumulated sales at the end of each day, after setting the price at daily exchange rate. This way, the exporter has hedged all of its exposure at the current exchange rate with a minimal differential with the target exchange rate. Also, the profit margin is preserved by adjusting the prices according to exchange rate movements.
  • Cost aware

Dynamic hedging reduces the hedge ratio when cost of hedging is high and increases hedge ratio when cost of hedging is low. In other words, this strategy takes on currency exposure when the cost of hedging exceeds the hedging benefits or the gains from not hedging could make up for currency movements.

  • Better risk-and-reward results

Dynamic hedging has proved to provide superior results from a risk and reward perspective as it takes current exchange rates into account, as well as long term mean-reverting patterns. Many people grow up with the notion that it’s not good to take risk, but risk is everywhere. If taken as an opportunity, it can reap quality rewards. And this opportunity is provided by dynamic hedging.

Point to note is that these benefits come at cost. Cost can be in the form of high premiums for customized option contracts, multiple strategies, time taken to analyze and potential loss due to inexperienced hedging. Therefore, it is highly recommended to take advice of experienced and professional Forex experts who can make the best of dynamic hedging. The Forex Risk Advisory Service of Myforexeye provides optimal risk management to its clients with its team of qualified and seasoned Dealing-room professionals.

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