Treasury Hedging: Forward Versus Option for a USD Receivable
Kaveri Exports expects USD 2.00 million in three months. Spot USD/INR is 83.20/83.25; three-month forward is 83.80/83.90. The company’s budget rate is ₹82.90 per USD. A bank offers a three-month USD put option at a strike of 83.50 with a premium of 1.20% of the INR notional. The treasurer can also leave the exposure unhedged. The company has a ₹1.50 crore overdraft and a covenant that forex losses cannot exceed 5% of budgeted export revenue. The CFO believes the rupee will depreciate to 85.00 but the board wants downside protection. No brokerage or tax is to be considered. The receivable is the company’s only forex exposure, and it has no natural offset; bank limits permit either a forward or an option.
1. Calculate the forward outcome, the option premium and the option’s net floor. At what maturity spot does the option beat the forward?
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Forward: the exporter sells USD at the bank’s bid of 83.80. Proceeds = 2,000,000 × 83.80 = ₹16.76 crore.
Option premium = 1.20% of the INR notional at the strike: 2,000,000 × 83.50 = ₹16.70 crore; 1.20% = ₹20.04 lakh. Per USD, premium = 20.04 lakh / 2,000,000 = ₹1.002. Net option floor if exercised = 83.50 − 1.002 = ₹82.498/USD, or about ₹16.50 crore.
At spot 82.00, exercise: net 82.498, better than unhedged 82.00 but worse than forward 83.80. At spot 85.00, do not exercise: net 85.00 − 1.002 = 83.998, slightly better than forward 83.80.
Break-even spot versus forward: spot − 1.002 = 83.80, so spot = 84.802. Above 84.802 the option beats the forward; below it, the forward is better. The option therefore buys upside above 84.802 at the cost of a floor about ₹1.30 below the forward rate.
2. Given the covenant and the CFO’s view, recommend a hedging strategy. Is leaving the exposure unhedged acceptable?
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The budget rate is 82.90. The forward locks 83.80, about 1.09% above budget, and fully protects the budget. The option floor of 82.50 is about 0.48% below budget, so it does not fully protect the budget unless the company treats the premium as an acceptable cost.
The covenant limit is 5% of budgeted export revenue: budgeted revenue = 2,000,000 × 82.90 = ₹16.58 crore; 5% = ₹0.829 crore. Leaving the full USD 2 million unhedged is not acceptable. At a spot of 78.00, the loss versus budget is (82.90 − 78.00) × 2,000,000 = ₹9.80 lakh, which breaches the ₹8.29 lakh covenant. At 80.00 the loss is ₹5.80 lakh, within the limit, but the company cannot rely on that.
The CFO’s 85.00 view is a speculation, not a hedge. A prudent strategy is layered: forward-cover 60–75% of the receivable to lock the budget and satisfy the covenant, and use the option for the remainder if the board wants upside. If the covenant is strictly enforced, hedge the entire exposure with forwards and treat any option premium as a separate budgeted cost. Do not leave the exposure naked merely because the CFO expects depreciation.