How traders are using currency options to hedge election and macro risks

US corporations are increasingly turning back to foreign exchange options to safeguard their cash flow, driven by fears that the upcoming election and differing central bank interest-rate policies could trigger significant currency volatility. Although currency swings have become less pronounced compared to the period from 2020 to 2022—when prices soared due to the COVID-19 pandemic and central banks began raising interest rates to combat inflation—there is still a notable risk of disruption to cash flows and earnings.

A survey conducted by MillTechFX in April showed that 90% of US companies planned to increase their purchase of options. In the second quarter, US corporations hedged 48% of their currency exposure, up from 46% in the previous quarter. This growing trend highlights the increased awareness among companies of the potential effects on their balance sheets as macroeconomic conditions evolve.

Currency options provide companies with the ability to lock in a worst-case exchange rate, thereby mitigating the impact of adverse currency movements while still allowing for potential gains if the currency rebounds. Currently, implied volatility for the world’s most traded currency pairs is around 7.68, down from 13.67 in 2022, making hedging more affordable and accessible.

Bankers have observed a significant rise in demand for option hedges, particularly as the November 5 election approaches. With Republican candidate Donald Trump proposing policies such as tariff hikes and immigration restrictions—measures that economists believe could lead to inflation—there is potential for the Federal Reserve to hike rates again, which could strengthen the US dollar (USD). Conversely, Democratic nominee Kamala Harris’ plans for housing assistance and curbing price gouging could have mixed effects on inflation, according to the Tax Policy Center.

US corporate executives are increasingly discussing the potential impact of the election in their earnings calls, particularly regarding tariffs and trade policies. The growing use of options indicates that companies are keen on securing affordable protection against market-moving events.

The divergence in central bank policies on interest rates is another factor driving currency volatility. A brief spike in volatility was observed earlier this month when investors unwound yen-funded trades after the Bank of Japan raised rates, reminding companies of the risks associated with currency exposure. As Federal Reserve Chair Jerome Powell signaled potential rate cuts, the dollar recently hit an eight-month low against a basket of currencies.

The use of collars—a hedging strategy that combines puts and calls—is becoming increasingly popular, allowing companies to benefit from currency rises while still maintaining protection. In addition, some companies are using exotic options to structure strategies that cover their future cash flows in local currencies, which can be particularly useful for transactions like mergers and long-term investments.

Companies that have been absent from the options market for years are now returning, with some seeking board approvals to implement these strategies. Given the heightened political tension and economic uncertainty, now is a crucial time for companies to reassess their hedging practices.

Conclusion

The traditional thinking that rate cuts automatically lead to a bullish stock market doesn't count for the complexities of today's global economy. Don’t be swayed by the traditional belief that interest rate cuts will automatically boost the stock market. In today’s complex economic environment, big investors are likely to shift their assets away from U.S. treasuries into safer options like gold or cryptocurrencies. This could lead to a weakened US dollar, making it difficult for the stock market to thrive.

Be cautious and consider the broader implications before making any moves.