In a competitive reality in which volatility in the foreign exchange rate between different currencies is part of the financial risks that can affect the company’s profitability, hedging activities are an important component of protecting the value of the financial assets, cash flow, and business activities.
Financial instruments for importers / exporters / startups: importers / exporters / startups have flows that enter or exit abroad, and the current activity (e.g., employee wage, raw material costs, and office costs) is usually conducted in the local currency, i.e., shekels, while the compensation or the spending is conducted in foreign currency.
The discrepancy between intakes and expenses for costs creates currency exposure, which could lead to harm and future losses that aren’t related to current business activity, but instead stem only from foreign exchange rates.
For example, a high-tech company has finished raising a huge sum from investors in several different currencies (e.g., dollar, euro, and pound), while the company’s current financing mostly uses shekels. As a company, it has a structure of costs and expenses, at the end of which there should be profits for the investors / entrepreneurs. There are several options for minimizing the currency risk as much as possible so that it will not burden the company’s performance.
Forward contract
A forward contract is a swap between two currencies, which will be carried out at a future date. At the date in which the contract is carried out, the following elements are determined: the two currencies, the contract sum, the payment date, and the cost of the contract, which is the forward rate at the payment date.
A forward contract creates certainty in regard to the company’s projected future cash flow.
The foreign exchange rate (i.e., the forward rate) is known ahead of time, and it determines the debit and credit sums in each currency; the contract costs are included in the forward rate.
The opposite contract can be carried out at any point, closing the position and thus securing the profit / loss.
In a forward contract, the bank pledges to buy / sell a predetermined amount of foreign currency to the company in exchange for shekels at a predetermined
foreign exchange rate at a specific future date, while the company pledges to buy / sell.
The contract’s risk: the amount of money the client loses as a result of the contract, in comparison to the market rate at the payment date, is unlimited and not known ahead of time.
The forward contract allows the company to promise itself the currency exchange rate at the payment date, based on the period of time that was determined at the point of purchase, which secures the contract’s profitability. The predetermined forward rate depends on two factors: the foreign exchange rate at the point in which the contract is carried out (the spot rate), and the difference between the two currencies’ interests.
Hedging exposure via the put/call options
What is an option?
An option is a financial instrument that gives its holder (the buyer) the right, but not the obligation, to buy / sell the base asset (the foreign currency) at the predetermined price and date.
The put option is an option whose purchase provides the company with complete protection against the foreign currency getting weaker in comparison to the shekel under the lower protection strike (xx strike put) at the payment date.
The call option is an option whose purchase provides the company with complete protection against the foreign currency getting stronger in comparison to the shekel above the upper protection strike (xx strike call) at the payment date.
There are several strategies for using these instruments to reduce costs. One such strategy is the cylinder contract.
Cylinder contract
A cylinder contract is a strategy that is made up of buying and selling the option in the same pair of currencies and at the same payment date. It allows the company to lower the hedging costs; on the other hand, the company cannot benefit from changes in the foreign exchange rate under the realization strike rate of the option that it will sell. The strategy provides the company with complete protection against the foreign currency getting stronger / weaker in comparison to the shekel at the option’s payment date; on the other hand, the company cannot benefit from the foreign currency getting stronger / weaker in comparison to the shekel up to the implementation exchange rate at the payment date.