First, some companies haven't hedged out far enough.  A hedging program should reach far enough into the future to protect revenues and expenses from short-term movements in currencies. For example, if a company protects euro-denominated revenue, but only as far as two months out, then the "hedge rate" is really only providing a view into future results for up to 60 days. This gives management very little time to react in the event of a major currency movement.

Alternatively, companies that hedge 12 months out will find that they have given themselves a chance to prepare for near-term movements in currencies by putting off the currency impact for a year. This longer-range strategy gives management time to plan and make adjustments based on what they expect to happen over the next 11 months, instead of simply reacting on the fly to each day's incremental change in euro prices.

Second, some companies are not able to hedge effectively.  In these businesses, legal-entity structure and functional-currency decisions of the past have put the organization in a position that undermines hedging activities. For example, under ASC 815, a company can hedge only "non-functional currency" transactions—in other words, transactions denominated in a foreign currency. If a company's German subsidiary is euro-functional, then the accounting guidance does not permit the parent company to hedge any of the subsidiary's revenues (or expenses) that are denominated in euro. Yes, the company could hedge against the potential economic impacts associated with the currency risk. But shareholders tend to punish companies for volatility in reported earnings, and without the special accounting treatment afforded by ASC 815, derivatives purchased as hedges would actually increase rather than decrease earnings volatility—a very unwelcome outcome.

Lastly, some companies may be hedging too little risk for their hedges to be effective.  Accounting rules dictate that when a company hedges margin (anticipated revenues and/or expenses), the hedged items must be "probable" to occur. The rules don't quantify "probable," but for discussion's sake, let's call that an 80 percent likelihood. It's possible part of the reason companies aren't adequately hedged is that they can't forecast as well as we think they can. The treasury function may fail to hedge a significant portion of the company's risks because they aren't confident enough in the organization's financial forecasts to consider most projected revenues and/or expenses to be more than 80 percent likely to materialize. This risk can be overcome by hedging smaller portions of revenues and/or expenses and building up layers of hedges over time, or by widening the hedge-able time period until the forecast becomes probable within a certain range of dates.

I also believe that U.S. companies are increasingly coming under pricing pressure overseas. What once cost $100 in the United States, and so sold in Europe for 75 euros when the exchange rate was at 1.33, may now be too costly for European buyers since the same $100 is equivalent to nearly 90 euros. Might the strong dollar be forcing some companies to reduce prices in local-currency terms? I think this too is driving some of the margin degradation U.S. companies have reported in recent months.

Options May Be a Good Option

Of course, understanding the cause of a problem does not solve the problem. The euro is weak, the dollar is strong, and there's no reason to expect that dynamic to change dramatically anytime soon. Like most global businesses, Hedge Trackers' clients are now grappling with how to mitigate the risk that the euro will depreciate further, without locking themselves into a price that represents a 12-year low.

One solution we've found is to use an option strategy, which protects margins from further weakness while allowing for participation in any currency-rate upside that may come. So, if a company was to protect itself against a further move downward in the euro, the treasury team could buy an option that locked in a floor of 1.11 but still allowed the company to benefit if rates shifted to a rising EUR-vs.-USD environment. In that situation, as the organization's USD results increased with the euro rate, new hedges could be layered in to follow the trend.

While no hedge strategy can provide complete immunity from the effects of unfavorable rate movements, a treasurer who understood options and how to deploy them effectively as hedges could certainly have avoided some of the short-term pain the strong USD has inflicted across many USD-functional multinational corporations. Using options rather than forwards in a currency-hedging program increases the up-front cost, but this approach also addresses two of the three weaknesses I see in the way companies are currently hedging currency risk.

First, options are well-suited for longer-dated hedges. Option-based hedging doesn't make sense for companies that are hedging risks only 60 days out, because there's no sense paying a premium for a two-month option; the company won't get much benefit from optionality so close to maturity. But an option strategy may have the advantage over forwards when hedging farther out because the date range that makes a forecast "probable"—and thus acceptable for hedge accounting—might also make it difficult for management to get comfortable with locking in results that far in advance.

In today's volatile currency markets, it may be a good idea for companies to take a longer-range view of their hedge programs. Treasurers need to weigh the cost of flexibility (options) against the certainty of fixing the exchange rate (forwards). Oftentimes, the best answer is a combination of both types of instruments, with options dominating longer-dated forecasted exposures while forwards lock in certainty closer to the date of exposure recognition.

The second way in which an option strategy may mitigate weaknesses in current hedging practices is that as U.S. companies face more and more pricing pressure in Europe, they can use options to ensure they'll benefit when rates move in their favor. No longer do they have to simultaneously use forward contracts to lock in euro at $1.11 and reduce their prices in euro terms. With options, companies can protect against a fall below $1.11 but reap the benefits if rates reverse to $1.20, $1.30, etc. This type of one-way hedge is clearly more palatable than "locking in" prices when the senior management team either expect currencies to move in the company's favor in the near future or want to remain flexible in case market conditions change unexpectedly.

How to Structure an Options-Hedging Program

Ultimately, the decision to use options comes down to an evaluation of the price the company is willing to pay to protect its revenue (or expense). Options are actually the most conservative derivative type because the risk is limited to the premium paid. You can think of an option like fire insurance: It's there if you need it, but you hope not to use it. If you don't exercise the option, it means that your revenues and expenses are better after conversion into your company's functional currency than they would have been under the rate you locked in. If a treasury organization decides to use options in its hedge portfolio, it needs to answer several key questions:

Should we hedge using out-of-the-money options or at-the-money options?  Since options are like insurance, they have an up-front fee. The fee, or premium, cost is dependent on many factors, including the volatility of the currency pair, time to maturity, notional size, and what the strike rate is relative to current market rates.

Some companies might want to save on premium by utilizing strike rates that are a little less favorable vs. today's rate. This protects against a big move (in case of a major structural fire, if you will) while still affording the upside should rates move in the company's favor. Other businesses just can't stomach a margin hit, and feel more comfortable using at-the-money option strikes to protect at or near today's rate. Your business type, margin profile, hedge horizon, market conditions, and other factors impact which type of options makes the most sense for your risk profile.

Do we have an option budget?  Companies that use options typically develop a budget and are held accountable for the premium spend they incur on their derivatives. The amount of the budget can vary, depending on the type of company, how critical the hedge impact might be on final results, and how expensive the options are relative to alternative hedging strategies.

If we enter into a zero-cost collar, instead of using put or call options, how does that change our possible outcomes and risk profile vs. a vanilla put or call?  A common progression for some companies is to desire the flexibility of an option, only to face sticker shock when they find out the cost. They then look to zero-cost collars. While collars can serve a valid hedging purpose, treasurers considering them need to realize how they differ from basic puts and calls.

The zero-cost portion of the collar is created by buying the put (or call) and financing that purchased option with a sold call (or put) with a slightly different strike rate. The two strikes create a gap that forms the collar. What you'll find is that the upside within the band is usually a little smaller than the downside within the band. Companies should be mindful of the implied cost of the downside in a collar hedge strategy and should think of it as similar to paying a premium. For example, when entering into a collar with a counterparty, is the approval level appropriate for the "financing" considered in your internal control process?

Also, the payoff profile or outcomes may look very different under a zero-cost collar. An option is like insurance: You pay the premium and are protected. The only downside is the premium. Not so for a collar, where technically you may end up paying out a lot of cash if rates move beyond the sold put/call strike rate. In the end, you can think of a collar as a "fat" forward which has a payoff profile that is more similar to a forward strategy than to a pure option strategy.

Options Make Predictability Possible

What was once a strategy for the more sophisticated corporate treasury teams is now becoming much more desirable for treasuries of all sizes. Although anecdotal, Hedge Trackers has seen more interest in options this year than at any time in the past decade. The strong dollar has changed treasuries' perspective, from running long-ago-implemented robo-hedge programs to really thinking about how the treasury function can be more strategic for the business and add value to the enterprise.

As market conditions change, treasury organizations must change to stay on top of currency risk and provide reliable, predictable results for management to guide the Street and satisfy stakeholders over the long term. An options strategy can help make predictability possible, even as currencies become increasingly volatile, without locking in those ugly exchange rates.

Jim Shepard is director of client services for Hedge Trackers, LLC. He has held senior roles in corporate finance and treasury at companies including KLA-Tencor, PeopleSoft, and BEA Systems, where he managed treasury operations, fixed income investments, cash flow forecasting, and multiple foreign currency cash flow and balance sheet hedging programs. Shepard holds a bachelor's degree in psychology from California State University, Hayward, and an MBA from the Leavey School of Business at Santa Clara University. He is a board member of the Silicon Valley AFP chapter and is a Certified Treasury Professional.