Increasingly volatile exchange rates arising from the Euro crisis have many companies revamping their approach to currency risk management. In the search for better risk mitigation, some companies are once again using products slightly outside the plain vanilla—looking beyond simple options and forwards. One mechanism of growing interest to corporates looking to improve efficiency of FX risk management is delta hedging for FX options. However, should volatility continue indefinitely currency impacts will be tough to deflect, regardless of hedging strategies.

Rather than simply buying an FX option at a set spot rate and hoping the currency goes in the direction you want, delta hedging allows a company to pay a premium based on the changing FX rate, so it remains in-the-money.

Delta hedging is based on changes in the price of the option—or the premium—as a result of a change in the price of the underlying FX rate. The delta is the change in premium for each basis-point change in FX price and the hedge ratio is the relationship between movements in delta and the FX rate.

The Association of Corporate Treasurers defines it as hedging of an option position against changes in the market price of the underlying asset. A delta hedge is established by buying or selling an amount of the underlying asset calculated by multiplying the number of related options by the delta of the options.

It is more efficient than using a simple option, because the premium is based on the changing delta, and it changes with the changing FX rate. For example, take a company that wants to hedge 100,000 units of US$/£ for six months. They get a spot rate of 1.49, Rather than simply buying an option to purchase 100,000 units at 1.49US$/£ in six months, they use delta hedging to cover volatility in either direction—to ensure they are hedged against an increase in the rate and that they also don’t just end up with an out-of-the-money call in six months.

One way that delta hedging is used in the FX market is to set a spot rate with one bank while bidding out an FX option with other banks in order to improve control during execution. It removes one of the factors that affect option premia—namely the spot rate.

However, a delta hedge is more expensive than a simple put or call. As with other insurance, you pay a higher premium for better coverage. In addition, delta hedging only works for small changes in exchange rate, so it must be updated regularly to maintain its validity—meaning a greater amount of time spent managing FX strategies than would be the case with a simple option or forward contract.