Importance of Option Hedging along with forward hedging

Optimum Foreign Exchange hedging need’s ability to manage uncertainty. While it might be tempting to think in binary terms – believing that the USD will either rise or fall – the market’s inherent uncertainty means that predictions often need to be more nuanced. Instead of a black-and-white perspective, it’s more accurate to adopt a probabilistic viewpoint.

Consider this simplistic view: “The USD will rise against the Indian Rupee (INR)” or its opposite: “The USD will fall against the INR.” Relying on such absolutes can be dangerous. A more nuanced approach to view making would be: “There’s a high probability that the USD will strengthen against the INR in the medium term, but it’s less likely to exceed 85.50. In the short term, the USD might weaken against the INR, but dropping below 82.00 seems less probable.”

When dealing with these more probabilistic projections, we need hedge instruments designed to efficiently reflect potential market movements to optimize hedge performance. This is where options hedging comes into play. Used judiciously, options can offer superior results when compared to other hedging instruments. Additionally, using forward contracts in combination with unhedged positions – that is, managing positions that are both hedged and open, and adjusting them dynamically – can also more accurately represent the market’s probabilistic nature. In essence, dynamically managing forward contracts is akin to the delta hedging techniques used with options. Just that the corporate treasuries should not ignore the precision maths behind it.

It’s crucial to emphasize the importance of dynamic risk management over static management (blind decision making) in this context. The fluidity of dynamic management allows for timely adjustments, ensuring that strategies remain relevant and effective in the face of changing market conditions yielding best possible outcome for the company. In other words, to achieve efficient frontier of corporate Fx hedging, one needs to have strategies and instruments and dynamism which reduces both risk and cost.

Furthermore, while safeguarding against worst-case scenarios in hedging is paramount, so is optimizing performance via the right strategy. In other words, to achieve efficient frontier of corporate Fx hedging, one needs to have strategies and instruments and dynamism which reduces both risk and cost. If not, inefficiencies in hedging can be masked by a company’s high operating margin, leading to hidden risks and potential competitive stress in long term.

So
👉 Use options along with forwards as hedge instruments
👉 Use Dynamic hedging and not blind hedging
👉 Don’t subsidize hedging inefficiencies with business gross margin.