One forecast, or many outcomes
Many hedging decisions start from a view: the rate will rise, so wait; it will fall, so hedge now. If the view is right the decision looks good, and if it is wrong the result is hard to explain. Either way, the decision says nothing about what the business would have faced in the other outcomes.
A more useful approach asks a different question. Not "where will the rate be?", which nobody can answer reliably, but "how does each alternative perform across the rates we could face, and how likely are they?".
A range of outcomes, with probabilities
Market prices contain an estimate of that range. Forward rates give its centre, and option prices, through implied volatility, give its width and shape. From them a probability can be attached to each possible rate at a future date. This market implied distribution is not a prediction; it is what the market is currently pricing, and it changes as prices change. Other views, such as bank forecasts or the business's own, can be compared against it, but they are views and should be treated as such.
Comparing alternatives across scenarios
A Canadian exporter expects $1,000,000 USD in six months. The forward rate is 1.3650. It compares leaving the exposure open, a forward, a vanilla put with a 1.3500 strike and a 0.0090 premium, and a zero premium collar between 1.3400 and 1.3900. Five scenarios for the rate in six months stand in for the full distribution, with illustrative probabilities.
| USD/CAD in six months | Probability | Unhedged | Forward | Vanilla put | Collar |
|---|---|---|---|---|---|
| 1.3000 | 10% | 1.3000 | 1.3650 | 1.3410 | 1.3400 |
| 1.3300 | 20% | 1.3300 | 1.3650 | 1.3410 | 1.3400 |
| 1.3650 | 40% | 1.3650 | 1.3650 | 1.3560 | 1.3650 |
| 1.4000 | 20% | 1.4000 | 1.3650 | 1.3910 | 1.3900 |
| 1.4300 | 10% | 1.4300 | 1.3650 | 1.4210 | 1.3900 |
| Probability weighted average | 1.3650 | 1.3650 | 1.3650 | 1.3650 | |
| Worst outcome | 1.3000 | 1.3650 | 1.3410 | 1.3400 | |
| Best outcome | 1.4300 | 1.3650 | 1.4210 | 1.3900 |
On $1,000,000 USD, the worst outcomes are $1,300,000 CAD unhedged, $1,365,000 CAD with the forward, $1,341,000 CAD with the put and $1,340,000 CAD with the collar. The put's rates are after its premium.
Every alternative has the same probability weighted average, 1.3650, the forward rate. That is not a coincidence. The option prices in the example are consistent with the scenario probabilities, as market prices are with the market's own distribution, so before dealing costs no hedge raises the average outcome. What hedging changes is the spread of outcomes: how bad the worst case can be, and how much of a good outcome is kept.
It also shows why the choice cannot be made from one forecast. Someone expecting 1.4000 would pick the put, someone expecting 1.3000 the forward, and someone expecting 1.3650 would see no difference. If the business weights the low scenarios more heavily than the market does, the forward's average looks better than the others; that is a view, and a policy should say how far views may influence a hedge.
What to measure
- Downside protection: the worst plausible outcome, or a low percentile such as the 5th.
- Participation: how much of a favourable move each alternative keeps.
- Budget outcome: the probability of achieving the budget rate, or the rate still needed on the open exposure.
- Expected outcome: the probability weighted average, which separates genuine costs, such as spreads, from the reshaping of outcomes.
- Liquidity and credit: a premium paid in cash, the credit facility a forward or collar uses, and any obligation created by a sold option.
Four things not to confuse
- An expected outcome is an average across all the scenarios. It is not a prediction of this outcome.
- A downside scenario is a plausible bad outcome, chosen so the business knows what it would face.
- A probability estimate comes from a model and today's market prices. It is an estimate, and it will change.
- A realized result is the one outcome that actually happened. Judging a decision by it alone confuses luck with judgment.
Data supports judgment; it does not replace it
Comparing alternatives on the same assumptions makes decisions consistent from one period to the next, and it leaves a record of what was considered and why. It does not decide how reliable the forecast is, what the business can afford to lose, or what its customers and lenders expect. Those remain decisions for the people responsible, inside the policy they have set.
In Vantry ATI
HedgeCore compares hedging structures for an exposure across a probability distribution, which can be market implied, a bank consensus, a blend, or the business's own, and ranks them on an objective it chooses: a balance of measures, expected value, protection or beating the budget. For each it shows the premium, expected value and probability of profit against converting at spot, the reduction in value at risk, and the probability of beating the budget. RiskCore then shows how one structure behaves: its payoff against a forward and an unhedged position, its outcome distribution, expected value, probability of profit, and 5th, median and 95th percentile results.
This article is general information about managing currency risk. It is not investment advice or a recommendation to use any instrument, and examples use illustrative rates and amounts, not quotations. Products are offered in Canada by Vantry Capital Inc., subject to eligibility and credit approval.