Risk reversal 

A risk reversal is another form of currency hedging. Like a protection option, a risk reversal allows you to set a worst case rate for a fee paid up front (a premium). In addition, it lets you set a best case rate. Because you have this, the premium is less. 

If the rate moves against you, you use your worst case rate. If it moves in your favour, you can take advantage of the spot rate. If the spot rate is better than your best case rate, you simply get your best case rate.

Advantages

• Guaranteed worst case rate
• You benefit up to the best case rate if the rate moves in your favour
• Your premium is reduced

Disadvantages

• You cannot benefit beyond your best case rate
• Up front premium

How this works for an importer

Let’s say that the Forward Contract rate is 1.23. You set your worst case rate at 1.23 and your best case rate at 1.35. You pay a premium of 1%.

Scenario 1 – On expiry, the spot rate is below 1.23

You buy your euros at 1.23

Scenario 2 – On expiry, the spot rate is above 1.23 and below 1.35

You buy your euros at the spot rate

Scenario 3 – On expiry the spot rate is above 1.35

You buy your euros at 1.35

How this works for an exporter

Let’s say that the Forward Contract rate is 1.23. You set your worst case rate at 1.23 and your best case rate at 1.11. You pay a premium of 1%.

Scenario 1 – On expiry, the spot rate is above 1.23

You sell your euros at 1.23

Scenario 2 – On expiry, the spot rate is below 1.23 and above 1.11 

You sell your euros at the spot rate

Scenario 3 – On expiry the spot rate is below 1.11

You sell your euros at 1.11

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