Contingent cash flow

Most hedging assumes the money is coming. The exporter has shipped, the invoice is raised, and the dollars will arrive.

Sometimes they might not. An order can fall through. A tender can be lost. A company can win an order and then be unable to supply it.

That is a contingent cash flow — a foreign currency flow that depends on something else happening first.

Hedging it with futures is dangerous, and the reason is simple. A futures contract is a commitment. If the underlying receipt never arrives, the hedge does not disappear with it. What was a hedge becomes an outright speculative position, with no limit on the loss.

The workbook is firm about the alternative. Put options are more suited as a hedging tool for contingent cash flow receivables. A bought option can simply be allowed to lapse. The most it can cost is the premium paid.

So the choice between futures and options here is not about cost or convenience. It is about what happens when the exposure you were hedging turns out not to exist.

The workbook's rule (Chapter 5, section 5.3.7.1). Put options are more suited as a hedging tool for contingent cash flow receivable. Two cases follow, and they are the examinable ones.

Case 2 — the order that cannot be filled. A company exports mango pulp to the Middle East. It receives confirmed orders 6 months in advance at a fixed price in USD. Sometimes it cannot fulfil the order quantity, because it cannot buy enough mango. Its practice was to hedge by selling USD in the futures market, and in the past it faced huge losses on FX hedging when it could not complete the orders and the USD strengthened significantly against the INR. The workbook's answer: the company could hedge a part of its exposure using currency options, specifically by buying puts, which would ensure its losses are limited to the premium paid and not beyond that when it cannot supply the goods.

Case 3 — the bid. The workbook calls the bidding process another typical contingent cash flow example. A firm bidding for an overseas project can quote its bidding price and protect itself by buying put options. Then:

Read the middle row twice. The futures hedger does not merely lose the hedge; he acquires a naked position he never wanted.

Cheapening the protection — Case 4. A jewellery exporter believes the rupee will appreciate from 83 to 82 in three months, but thinks a stronger dollar against other currencies could prevent appreciation beyond 82. Rather than a plain vanilla put, it can buy an ATM or ITM put and sell an OTM put to reduce cost. That is a bear put spread; the same payoff can be built with calls as a bear call spread. The actual strikes depend on premiums and the objectives of management.

When the flow arrives early — Case 5. Because exchange traded options are cash settled, a hedger whose money comes in before expiry can unwind the option rather than exercise it, and the unwinding gain or loss is folded into the effective price.

The payables mirror. For a contingent payable, the same logic runs through bought calls — section 5.3.7.2 and the protective call.

No figure for the contingency itself. The workbook gives no probability, no threshold for when a cash flow counts as contingent, and no rule on how much of one may be hedged. It gives worked premiums for the strategies and nothing for the concept. Judgement, not a formula.

The mango pulp exporter, both ways. Built on the workbook's Case 2 and its own put premium of Rs 0.20 at a strike of 83.00 from the same section.

The company holds a confirmed order for USD 5,00,000, six months out. In the event it can source only enough mango for USD 3,00,000 of it, and USDINR strengthens from 83.00 to 85.00.

Route A — short futures on the full USD 5,00,000 (500 lots).

The Rs 4 lakh hole is the USD 2,00,000 of futures that had no receivable behind them — 200 lots left naked when the order shortfall appeared. This is the huge loss the workbook describes.

Route B — bought puts on the full USD 5,00,000, strike 83.00, premium Rs 0.20.

The premium was the entire downside. Rs 1,00,000 of known cost replaced Rs 10,00,000 of open-ended loss.

And if the contingency had gone the other way — full order shipped, rupee appreciates to 81.00:

So the option cost Rs 1,00,000 for protection that was slightly worse when the flow did arrive. That Rs 1 lakh is the insurance premium on the contingency, and the workbook's point is that it is worth paying when the flow might not arrive at all.

The floor a bought put sets. With a strike of 83.00 and a premium of Rs 0.20, the exporter's minimum rate is 83.00 - 0.20 = Rs 82.80, with the upside left open.

Chapter 5, section 5.3.7.1 (Buying protection with put options), is the source: the statement that put options suit contingent cash flow receivables, the mango pulp case, the bidding case, the bear put spread variant and the early-unwinding case. Section 5.3.7.2 is the payables mirror. The examinable question is almost always comparative — why an option rather than a futures contract for an uncertain flow — and the answer the paper wants is that an unfulfilled exposure leaves a futures hedger with an unlimited-loss speculative position, whereas an option holder loses at most the premium.

• The risk is not that the hedge fails. It is that the hedge survives the exposure. Futures do not lapse when an order falls through.
• Buy the option; do not write it. Only the buyer has the capped loss. A written option carries the obligation and the unlimited risk.
• Puts for contingent receivables, calls for contingent payables. Direction still follows the cash flow, not the view.
• The maximum loss is the premium — the workbook says so in terms. It is not the premium plus the strike, and not the notional.
• A lost bid with a favourable move can still be exercised at a profit. The workbook notes this, and candidates often assume a lapsed contingency means the option is worthless.
• The bear put spread cheapens the cover; it does not remove the cost. And selling the OTM put caps the protection below that strike.
• A contingent cash flow is not the same as a partial hedge, though the workbook's answer to the first is often to hedge only part with options.
• Do not confuse it with a contingent liability in the accounting sense. This is an uncertain future currency flow, not a disclosed balance sheet item.