Minimise exchange rate risks
Transactions in foreign currencies often entail deferred payment terms. That means an open (unprotected) exchange position could jeopardise the profitability of your transactions, depending on how the currencies in question evolve.
A forward exchange contract allows you to fix today the rate at which the currency you will receive (in the case of sales) or pay (in the case of purchases) will be converted on a given date in the future. Forward exchange contracts can be concluded with terms from one business day to ten years.
An option gives you the right, but not the obligation, to buy a certain amount of currency. You can choose to exercise it or not, depending on the evolution of the currency involved. The option sets a predetermined price for buying (call option) or selling (put option) the currency during a set period (American-style options) or on a set date (European-style options). On the day you need to buy or sell the currency, you merely have to compare its rate on the spot market with the rate guaranteed by your option and then choose the more advantageous of the two.
Hedge your exchange risk at zero cost
A ‘cylinder’ combines a call and a put option. It fixes a range of exchange rates, confined between the exercise price of the call option and that of the put option. That protects the buyer from a rise in the exchange rate and allows them to benefit from a lower sales price. Conversely, it protects the seller from a fall in the exchange rate and allows them to benefit from a higher sales price.
On the expiry date you never pay more than the exchange-rate cap (or receive less than the exchange-rate floor) and never less than the agreed exchange-rate floor (or more than the agreed exchange-rate cap). Since there are two premiums involved (one paid and the other collected), the cost of the hedge is reduced, or even cancelled out (‘zero cost’ construction).