III. Financial Instruments: Specific instruments 

3. Other instruments used for hedging purposes

3.1. Forward contracts

A forward contract is a contract in which a company sells one currency against another at a fixed rate but with a settlement at a future date (with a future value date). The forward rate reflects the impact of the exchange rate differential between the two currencies. 

Assumption: A company sells today 1000 EUR against USD for cash settlement in one year:

Calculation of the forward rate:

Mark to market of a forward contract.

The value of a forward contract will evolve with the variation of:

• the spot rate
• interests rates
• time to maturity

Hedge profile and impact: A forward contract allows to fix the exchange rate, which means we will not suffer from an unfavorable evolution of the exchange rate but we will not profit from a favorable evolution of the rate either.

3.2. Currency Options (usually used for hedging purposes)

A currency option is a contract in which a company buys (sells) the right (but not the obligation) to purchase (call) one currency against another (put) at a pre-agreed price (strike) on a specified date (maturity). The purchaser has to pay a premium to the seller.

The level of the premium paid depends on the difference between

• the strike price and the spot rate
• the volatility of the currency pair and
• the maturity of the option.

An option is a financial asset when bought, a financial liability when sold.

There are many different kinds of options that can be combined into complex structures. The jargon used to describe the different kinds of options is somewhat poetic: plain vanilla , American , European, Asiatic, Bermudian, digital, exotic, butterfly ...

For more information, contact the Treasury Department.

Mark to market of a currency option

The value of an option is the sum of its intrinsic value and time value. It can never be negative.

• The intrinsic value is zero if the option is “out of the money” or in other words if the delta between spot rate and strike price is negative.
• The time value is calculated as the difference between the total value of the option and the intrinsic value. The time value varies with the volatility of the currency pair (the higher the volatility, the higher the time value), the time to maturity (the longer the maturity the higher the time value).

According to IAS 39, even if the contract qualifies as hedge, the variation of time value will always be considered as ineffective and hence reported in the income statement.

Hedge profile and impact: An option will protect us against an unfavorable rate evolution leaving open all the upside potential in case of a favorable evolution. But there is a price to pay for it, which is called the premium.