Practical Currency Hedging Question with Options

[investor-man]

I don't trade options, so I need some help from you experts. I work for an American company and we're hiring some French employees who will be paid in euros. If currency hedging is practical, we're interested in making sure their yearly wage doesn't fluctuate from today's current cost. Please let me know if my thinking is straight on this:

 

Assuming we want to spend $100k/year on them and today's exchange rate (for simplicity) is .9 dollars per 1 euro, we could purchase options to buy €111,111 euros a year from now for some amount of money, and then about year from now if it's worthwhile we can either sell those options to make up the difference in currency fluctuations, or let them expire if things have moved in our direction?

 

Is the above correct? Also, any idea how much those options contracts will cost? Is this practical, or do I just say f*ck it and not worry about hedging?

 

Thanks!

[Guest Schwab711]

http://www.investopedia.com/articles/forex/11/hedging-with-currency-swaps.asp

http://en.wikipedia.org/wiki/Currency_swap

 

Could save money vs. options but you take on CP risk and you have an obligation vs an option.

[Straddle]

Your reasoning is correct, but keep in mind the premium for these options will be expensive and highly correlated with the implied volatility in the EUR/USD currency. Intuitively I would say the premium on those currency options will immediatly cause a cost for you which then needs to be set off by a move of the spot price (EUR/USD).

 

A far better (and simpler) hedge here is to just enter into a forward contract today with expiration date next year (the date you need to pay the salaries). This will be far cheaper (you just pay the forward points) and the pay-off for your firm is 100% certain (and the currency risk is eliminated).

[Sunrider]

Your reasoning is correct, but keep in mind the premium for these options will be expensive and highly correlated with the implied volatility in the EUR/USD currency. Intuitively I would say the premium on those currency options will immediatly cause a cost for you which then needs to be set off by a move of the spot price (EUR/USD).

 

A far better (and simpler) hedge here is to just enter into a forward contract today with expiration date next year (the date you need to pay the salaries). This will be far cheaper (you just pay the forward points) and the pay-off for your firm is 100% certain (and the currency risk is eliminated).

... more like a series of 12 swaps since salaries have to, presumably, be physically paid every month?

[Hielko]

I doubt that hedging is cost effective when you want to hedge small cash flows like this.

 

But if you want to hedge an option wouldn't be a good choice for the reasons given by Straddle and Sunrider.

[investor-man]

Thanks for the responses! Very helpful!

[jawn619]

Hey I have a friend who works as an equity options market maker and so maybe I can shed some light.The way it works for equity options is that when you buy an option, it actually implies a certain percentage move in annualized terms. I'm guessing its the same for FX but the volatility you pay is probably lower because its more liquid. It's like buying insurance so say you go out and hedge your Euro exposure with options, I checked some recent quotes and you're likely paying around 10% implied volatility per year so if that means that if the currency moves less than 10% you lose to the premium.

 

Conclusion: like the others said it's probably not worth paying the premium to hedge it because there's a built in hurdle and I'm sure the volatility is pumped because of all the macro news.

 

Hope this helps.

 

P.S. Pumped for Saturday!