FX Collar: How It Works and When to Use It

Exchange rates move fast, and if you’re getting paid or paying suppliers in foreign currency, this high volatility can hurt your bottom line.

That’s where an FX collar comes in. It’s a hedging tool that helps you lock in a favourable exchange rate range, so you know the minimum and maximum you’ll get.

This guide will cover:

✅What an FX collar is and how it works

✅The benefits and risks of using one

✅An example of how businesses apply collars

✅How it compares to forwards and options

Let’s get right in.

What Is an FX Collar?

An FX collar is a structured hedging strategy that helps protect your business from unfavourable exchange rate movements without sacrificing all the potential upside if rates move in your favour.

Think of it as setting a floor and a ceiling for your exchange rate. You lock in a worst-case rate to avoid losses, and a best-case rate beyond which you won’t benefit further.

To create this range, you combine two options:

• Buy an option to protect against losses (e.g. if your currency weakens)
• Sell another option to reduce or eliminate the cost.

The result is a defined range where you know the best and worst rate you’ll get.

How an FX Collar Works

Here’s how it’s typically structured:

1. You buy a protective option, which gives you the right to exchange currency at a specific rate (the floor) if the market moves against you.
2. You sell another option, which gives up some of your upside if the market moves in your favour (the ceiling), but in return, it helps cover the cost of the first option.
3. These two options create a range.

• If the rate drops below the floor, you can still exchange at the floor rate.
• If the rate rises above the ceiling, you must settle at the ceiling rate.
• If the rate stays between the two, you trade at market rates.

In many cases, the premium you receive from selling the second option offsets the cost of the first, resulting in a zero-cost collar.

Now, let’s take a look at how collars work in practice.

Use Case: How a Hong Kong Importer Uses FX Collar

A wine importer based in Hong Kong needs to pay EUR 500,000 in 6 months. They’re worried the euro might go up, which would make the payment more expensive in Hong Kong dollars. But they don’t want to pay a high premium for protection.

To manage this exposure, the importer enters into an FX collar:

• Buys a EUR call option at 8.50 to set the maximum exchange rate they are willing to pay
• Sells a EUR put option at 8.40 to offset the cost of the call
• Because the premiums cancel out, the collar costs nothing upfront

At the end of 6 months, here’s what happens depending on the EUR/HKD rate:

FX Collar vs Forwards vs Options

If you're managing currency risk, you’ve likely come across three common tools: FX forwards, FX options, and FX collars. Each works differently and suits different needs.

Below is how they compare.

FX forwards are suitable when you need full budget certainty and can commit to a fixed rate. They’re simple and have no upfront premium, but don’t allow you to benefit from favourable market moves.

FX options are the most flexible. You choose whether to use them based on market rates at maturity. However, they come with a higher cost, which may not suit all SMEs.

FX collars are ideal if you want a balance: protection against unfavourable movements, some potential upside, and minimal or zero premium cost. For many small businesses, collar strategy offers a practical middle ground.

When deciding, think about your payment timeline, cash flow certainty, and how much risk (or opportunity) you’re comfortable with.

Pros and Cons of Using FX Collar

FX collars can be a valuable tool for businesses, but they come with trade-offs. Here's a breakdown of the key benefits and risks to consider.

Benefits of FX Collar

• Lock in a range to plan your budget: A collar gives you a clear range for your exchange rate. You know the worst rate you’ll get and the best rate you can hope for. This helps with accurate budgeting and cost control.
• Reduce or eliminate the cost of buying an option: Options can be expensive. With a collar, you sell one option to offset the cost of the one you buy. In many cases, this means you don’t pay anything upfront.
• Keep some upside if the market moves in your favour: If the exchange rate improves but stays within your collar range, you can benefit. This makes it more flexible than a forward contract, which locks you into a single rate.
• Good for fixed payment timelines: Collars work well when you know exactly when and how much foreign currency you’ll need, like paying a supplier or settling an invoice in a few months.

Risks of FX Collar

• Your gains are limited if the market moves strongly in your favour: If the exchange rate improves beyond your upper limit, you won’t get the better rate. You’re locked in at the cap.
• You’re committed to the floor if the market drops: If the rate falls below your lower limit, you still have to trade at that lower strike, even if the market is offering a better deal.
• More complex than forwards: A collar involves two option contracts and two strike prices. It’s not overly complicated, but you’ll want help from an FX provider if you’re new to options.
• Not meant for speculation: Collar options are designed to protect against FX risk, not to help you profit from market moves. They’re best used when you have a real business need to manage currency exposure.

Final Note

An FX collar is a practical way to manage currency risk. It gives you protection within a set range, often at no cost, while still allowing some upside.

It’s a good fit for businesses with predictable foreign currency payments, but it’s important to understand the trade-offs. If you're unsure, speak with an FX provider to find the right setup for your needs.