Forward extra is considered as a very popular currency hedging strategy. This strategy consists of buying a vanilla option and selling an exotic barrier option. 

The forward transaction is admittedly the most popular FX hedging tool, but it may only be so because it is simple. However, companies that have above-average financial knowledge, choose to hedge their currency exposures through option-based transactions. In this way they produce for themselves deals that are tailored to their unique needs, such as protecting budget rates, limiting loss potential, and there are many other reasons.

So, what other hedging strategies are there?

Well, Forward extra is considered as a very popular currency hedging strategy. This strategy consists of buying a vanilla option and selling an exotic barrier option.

What is an exotic option?

An exotic option is like a vanilla option but with the addition of some condition to its existence. This section will describe the use of barrier options for hedging purposes, and that because this category is usually relevant for hedging.

Why use Exotic Options for currency exposure hedging ?

The use of exotic options can be a means of lowering a premium compared to the Vanilla option, and/or adjusting the hedging strategy risk structure to the firm's risk aversion.

Forward extra components:

• If exposure direction is to the depreciation of the major currency against the minor, the strategy consists of buying vanilla put and selling knockin call at the same strike. The call barrier direction is up & in.

• If exposure direction is to the appreciation of the major currency against the minor, the strategy consists of buying a vanilla call and selling knockin put at the same strike. The put barrier direction is down & in.

Ex 1: Hedge against EUR appreciation relative to the USD

Explanation:

• Hedge against EUR appreciation above 1.0851. The call option buyer has the right to buy EUR and sell USD at 1.0851.

• Indifference range between rates 1.0851 to 1.0419 and +1 Pips (1.0420). As long as the market rate is not traded during the option life at rate 1.0419 or below, the hedging instrument will not cause a loss.

• If the market rate is, during the option life, 1.0419 or below this rate, the trigger will become active and create a commitment to buy Euro at the rate of 1.0851 (sell put strike).

Ex 2: Hedge against EUR depreciation relative to the USD

Explanation:

• Hedge against EUR depreciation below 1.0792. The put option buyer has the right to sell EUR and buy USD at 1.0792.

• Indifference range between rates 1.0792 to 1.1149 -1 pips (1.1148). As long as the market rate is not traded during the option life at rate 1.0419 or above, the hedging instrument will not cause a loss.

• If the market rate is, during the option life, 1.1149 or above this rate, the trigger will become active and create a commitment to sell Euro at the rate of 1.0792 (sell call strike).

The same strategy can be implemented and use a European barrier type, instead of an American barrier as described in this example. 

Barrier type: European or American, what is the difference?

The difference between a European trigger and an American trigger is the timing at which the trigger becomes active (or caught).

• In European Trigger the test whether the trigger is caught or not - is performed on the expiry date and at a certain time on that date.

• In contrast, an American trigger can be caught and become active throughout all the options life.

Knockout trigger, if caught - makes the option unexercisable.

Knockin trigger, if caught - makes the option possible to exercise.