What is an FX Collar?
An FX Collar involves buying a Cap and selling a Floor on the same currencies with the same expiration date. The two Options set the upper and lower strike prices.
It allows the Holder to manage foreign exchange risk and minimise the cost of the hedging.
How does it work?
A UK firm of exporters will be receiving $10 million in a year’s time. They want to enter into a hedging contract to protect the conversion rate and buy a dollar Put/sterling Call option. However, they do not want to pay a premium so they offset that by selling a dollar Call/sterling Put option with an equal premium. The dollar Put option limits the risk of dollar depreciation, while the dollar Call option restricts any benefit from any dollar appreciation.
- The Holder pays no upfront premium
- Offers protection against unfavourable currency moves
- The Holder can benefit from rates between the cap and the Floor
- Limits the Holder’s ability to benefit from currency appreciation
- Using a Forward contract could offer a better rate
- Termination could incur extra costs depending on the market rate at that time
FX Collar scenarios: