CFH: Foreign Exchange Collars Used as Hedging Transactions (SAP Library

CFH: Foreign Exchange Collars Used as Hedging Transactions

General Information on Foreign Exchange Collars

Foreign exchange collars (option spreads) involve the purchase of a call option and the sale of a put option, or vice versa.

Example

On January 1 of the current year, you intend to purchase goods on February 1 the following year at a value of USD 1,000. Your local currency is EUR. The exchange rate for USD is 1.20 on January 1 of the current year.

If the exchange rate drops in the meantime, however, the payment you make in EUR will be greater than expected. To hedge this risk, you buy a European call option to purchase USD 1,000 at an exchange rate of 1.17 (USD/EUR). You pay a premium of USD 12 to buy the option.

To clear the premium payment, you sell a European put option so that the sale of USD 1,000 occurs at an exchange rate of 1.23 USD/EUR.

The exercise key date for both options is January 1 the following year.

In this example, you use a foreign exchange collar to hedge an exchange rate of less than 1.17. At the same time, profit gained due to a higher exchange rate is limited to the amount that you would receive if the exchange rate were to increase to 1.23. The exchange rate spread from 1.17 to 1.23 allows you to profit from favorable exchange rate developments.

You can also use foreign exchange collars (also known as range forwards) to determine upper and lower limits to exercise purchase and sale transactions.

Mapping Foreign Exchange Collars in the System

Foreign exchange collars are mapped in the system using two options on forward exchange transactions. The two options are linked to each other with reference category OPT - Option Spread. To create and use both options directly in an option spread, on the SAP Easy Access screen, choose Treasury and Risk Management → Transaction Manager → Foreign Exchange → Trading → Currency Option Entry – Spread (transaction TI4B).

Alternatively, you can create both options separately then link them with reference HMT – Reference in Hedge Accounting or OPT – Option Spread. On the SAP Easy Access screen, choose Treasury and Risk Management → Transaction Manager → Derivatives → Back Office → Reference → Create (TBR6).

Valuation and Effectiveness Test

Usually, you cannot assign more than one option to an exposure since the nominal amount of the exposure has already been hedged with the first option. You can therefore only hedge exposures with foreign exchange collars if the options are linked to the reference in categories OPT - Option Spread or HMT – Reference in Hedge Accounting. You can use the reference to assign more than one option to the exposure, even if the total nominal amount of the options exceeds the exposure value. In this case, the system checks only the maximum nominal amount of a reference.

The effectiveness test and measurement are carried out separately for each currency option. When doing this, the system compares the values of the underlying with the exposure. In practice, the effectiveness of the hedge is determined by the group of assigned derivatives.

Creating a Hedging Relationship

To create a hedging relationship, proceed as follows:...

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1. On the SAP Easy Access screen, choose Treasury and Risk Management → Transaction Manager → Hedge Accounting for Exposures → Hedging Relationships → Hedge Plan (transaction THMEX).

2. Specify the risk category Exchange Rate Risk and the required date for the new hedge plan. Choose the transaction activity Purchase or Sell.

3. Choose the Hedged Item tab page and select the relevant exposure. Specify the transaction category Planned Transaction or Firm Commitment. Choose the hedge category Cash Flow Hedge.

4. On the Hedging Relationship tab page, specify the first option of the currency option collar. If you have assigned an option to a currency option collar, the system displays the Reference Category and Reference fields.

5. Choose the hedge strategy 405 – Options: Intrinsic Value Spot Rate or 400 - Option Intrinsic Value, Forward Rate Disc. Period/Period.

6. Create another hedging relationship and specify the second option of the currency option collar as the hedging instrument. Choose the hedge strategy that you selected for the first option.