DM/Dollar Hedging Strategy: Put Options vs. Forward Contracts

Introduction and the Sell-or-Keep Decision

The sell/keep decision for the put option rests on several converging factors. First, the strong volatility that currency markets were experiencing led to a significant appreciation of the option price. Because options are commonly used as hedging mechanisms, they become most valuable precisely when market direction is uncertain. Selling the put option at this point would therefore yield a handsome profit. For illustration, if we consider that on September 18th the price of the put option was 1.9 cents per DM (as shown in Exhibit 4), the following profit could be realized:

($0.019/DM − $0.014/DM) × DM 7,600,000 = $41,800

This profit is calculated by subtracting the initial price paid on August 17th from the value of the put option on September 18th, then multiplying by the total notional amount covered.

However, when deciding whether to sell the put option, one must not lose sight of its primary purpose — not to generate a profit, but to protect the company against a bearish DM/USD exchange rate that could have imposed significant costs in the relevant months. The key question, therefore, is what outlook can reasonably be formed for the DM/USD rate over the next few days and through to the December repatriation of profits.

The French positive response to the Maastricht Treaty and its proposed monetary unification of the European Community provides an important directional signal. The main cause of dollar appreciation in September — beyond German interest rates — was the instability and weakness of European currencies, which had suffered steep devaluations in a short period. Monetary unification would eliminate much of this instability, so the positive signal from France would likely exert downward pressure on the dollar, at least in the near term.

Exchange Rate Drivers: Interest Rates and European Currency Instability

In this context, the most effective solution appears to be exercising the put option while values are still elevated and then re-purchasing it at a lower premium later. This approach preserves the hedging position while also capturing a profit from the period of heightened volatility — effectively speculating on a favorable moment in the currency market without abandoning the underlying risk management objective.

To understand the September events fully, it is useful to review what had occurred earlier and how the DM/USD exchange rate had fluctuated in the months prior. The declining exchange rate between the Deutsche Mark and the U.S. dollar had one principal explanation: the substantial difference between interest rates in the two countries. German interest rates had reached 9.75% in July, which clearly explained why demand for the Deutsche Mark was rising. Higher interest rates mean higher returns on deposits, bonds, and treasury bills denominated in that currency. As economic theory holds, higher returns drive higher demand for the instrument offering them.

In September, however, German interest rates began to decline — falling to 9.5% — which, following the same logic, reduced demand for the Deutsche Mark. A further factor compounded this effect: the British pound and the Italian lira suffered severe devaluations in a short period, prompting investors to seek the relative stability of the U.S. dollar. Demand for the dollar subsequently grew, and the DM/USD exchange rate rose accordingly.

The put option held against this backdrop had served as an excellent hedging mechanism against a bearish Deutsche Mark market, exactly as intended during the period from July through early September. Once the dollar entered a phase of appreciation against the Deutsche Mark, however, the put hedge became less necessary, since the market was now moving in a bullish direction for the dollar. The combination of declining German interest rates and growing demand for the U.S. dollar pointed clearly toward a continued rise in the DM/USD exchange rate.