What it means
Hedging protects a business from price moves, but the protection normally costs money. An option that guards against a rise in the price of a raw material, for instance, requires an up-front premium.
A zero-cost strategy avoids that payment by pairing the purchased option with a sold one that brings in the same amount. The seller of an option accepts an obligation in return for the premium.
That means the business is trading a risk it does not like for a risk it is more willing to carry. For example, a manufacturer worried about rising metal prices buys protection against a rise and sells protection against a fall, accepting that it will not benefit if prices drop a long way.
Zero-cost strategies take several forms, including collars, risk reversals and participating forwards. Each one trades something in exchange for a cheaper hedge.
Choosing among them depends on how large a move the business can tolerate and how much upside it is willing to forgo. The label can mislead.
Zero cost refers only to the premium at the start, not to the full economic cost over the life of the trade. If the market moves strongly against the position, the business may owe a large settlement amount, and it may be asked to post cash or collateral to its bank.
Good practice is to measure the strategy against the plain alternatives. A finance team should compare it with an outright option, a forward contract and doing nothing, and then judge which risks it is truly removing.
Board approval and clear hedging policies are important, because the sold option can create a large exposure.
In practice
Real-world examples.
Example
An importer expects to pay a foreign supplier in six months and wants to cap its currency cost. It buys a currency call and sells a put at a rate chosen so that the two premiums offset. Its worst-case cost is fixed, but it cannot benefit if the currency weakens a long way.
Example
A property company has a floating-rate loan of $20,000,000 and buys an interest rate cap. To fund the premium, it sells a floor, which means it gives up the benefit if rates fall sharply. The treasurer shows the board the range of interest costs under both outcomes.
Example
A farmer uses a zero-cost structure to protect the price of next season's wheat. The bank buys her a put and she sells a call at a higher price, with the premiums netting to zero. She accepts a ceiling on her sale price in return for a guaranteed floor.
Formula
Calculation
Net premium = Premium paid on purchased options - Premium received on sold options
A manufacturer expects to buy 2,000 tonnes of copper in six months. It buys a call option that protects against a rise, paying $40 per tonne, which is 2,000 x 40 = $80,000. It also sells a put option, receiving $40 per tonne, which is 2,000 x 40 = $80,000. The net premium is 80,000 - 80,000 = $0. If the price falls well below the put strike, the company must buy at the higher strike under the put, so it gives up the benefit of cheap copper.Case study
Seen in the real world.
Calloway Beverages is an illustrative, fictional drinks company that buys 5,000 tonnes of sugar a year. The finance director wants protection against a price spike but does not want to pay a premium during a year of tight cash. The bank offers a zero-cost structure in which the company buys a call at $600 a tonne and sells a put at $480 a tonne.
If the sugar price rises to $700, the company pays only $600, saving 100 x 5,000 = $500,000. If it falls to $400, the company must pay $480 under the put, so it pays 80 x 5,000 = $400,000 more than the market price. Both outcomes are agreed in advance and written into the hedging policy.
The illustrative lesson is that the structure removed the up-front cost but not the economic trade-off. Calloway's board accepted the exchange of a downside it could manage for protection against the spike it could not.
Watch out
Common mistakes.
- Assuming zero cost means no risk, when the sold option can create a large loss if the market moves the wrong way.
- Forgetting collateral calls, when the bank may require cash to be posted if the position moves against the company.
- Using the structure for a risk the business does not actually have, when this turns a hedge into speculation.
Questions
People also ask.
Is a zero-cost strategy always better than buying an option?
No, it saves the premium but gives up potential gains, so the best choice depends on the business and its view of the market.
What are common zero-cost structures?
Collars, risk reversals and participating forwards are common examples.
Who should approve one?
The board or a treasury committee should approve it under a written hedging policy, with the finance team monitoring it regularly.
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