Fx options guide pdf

FX Barrier Options

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Fundamentally, there are three types of foreign exchange exposure companies face: transaction exposure, translation exposure, and economic or operating exposure. This is the simplest kind of foreign currency exposure and, as the name itself suggests, arises due to an actual business transaction taking place in foreign currency. The exposure occurs, for example, due to the time difference between an entitlement to receive cash from a customer and the actual physical receipt of the cash or, in the case of a payable, the time between placing the purchase order and settlement of the invoice.

Example: A US company wishes to purchase a piece of equipment and, after receiving quotes from several suppliers both domestic and foreign , has chosen to buy in Euro from a company in Germany. This arises because the parent company has reporting obligations to shareholders and regulators which require it to provide a consolidated set of accounts in its reporting currency for all its subsidiaries.

The example below shows the financial performance of the subsidiary in its local currency of Euro. The financial performance in USD looks a lot worse. This type of exposure can impact longer-term strategic decisions such as where to invest in manufacturing capacity. In my Hungarian experience referenced at the beginning, the company I worked for transferred large amounts of capacity from the US to Hungary in the early part of the s to take advantage of lower manufacturing cost.

Foreign Exchange Option Pricing (eBook, PDF) von Iain J. Clark - Portofrei bei

It was more economic to manufacture in Hungary and then ship product back to the US However, the Hungarian Forint then strengthened significantly over the following decade and wiped out many of the predicted cost benefits. For example, a US furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly.

The first question to ask is whether to bother attempting to mitigate the risk at all. It may be that a company accepts the risk of currency movement as a cost of doing business and is prepared to deal with the potential earnings volatility. Additionally, the company may be trading with a country whose currency has a peg to the USD, although the list of countries with a formal peg is small and not that significant in terms of volume of trade with the exception of Saudi Arabia which has had a peg in place with the USD since For those companies that choose to actively mitigate foreign exchange exposure, the tools available range from the very simple and low cost to the more complex and expensive.

Companies in a strong competitive position selling a product or service with an exceptional brand may be able to transact in only one currency. For example, a US company may be able to insist on invoicing and payment in USD even when operating abroad.

In practice, this may be difficult since there are certain costs that must be paid in local currency, such as taxes and salaries, but it may be possible for a company whose business is primarily done online.

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Many companies managing large infrastructure projects, such as those in the oil and gas, energy, or mining industries are often subject to long-term contracts which may involve a significant foreign currency element. These contracts may last many years and the exchange rates at the time of agreeing to the contract and setting the price may then fluctuate and jeopardize profitability. It may be possible to build foreign exchange clauses into the contract that allow revenue to be recouped in the event that exchange rates deviate more than an agreed amount. In my experience, these can be a very effective way of protecting against foreign exchange volatility but does require the legal language in the contract to be strong and the indices against which the exchange rates are measured to be stated very clearly.

These clauses also require that a regular review rigor be implemented by the finance and commercial teams to ensure that once an exchange rate clause is triggered the necessary process to recoup the loss is actioned. Finally, these clauses can lead to tough commercial discussions with the customers if they get triggered and often I have seen companies choose not to enforce to protect a client relationship, especially if the timing coincides with the start of negotiations on a new contract or an extension. A natural foreign exchange hedge occurs when a company is able to match revenues and costs in foreign currencies such that the net exposure is minimized or eliminated.

For example, a US company operating in Europe and generating Euro income may look to source product from Europe for supply into its domestic US business in order to utilize these Euros. This is an example which does somewhat simplify the supply chain of most businesses, but I have seen this effectively used when a company has entities across many countries.

The most complicated, albeit probably well-known way of hedging foreign currency risk is through the use of hedging arrangements via financial instruments. The two primary methods of hedging are through a forward contract or a currency option. Forward exchange contracts.

Buying options

A forward exchange contract is an agreement under which a business agrees to buy or sell a certain amount of foreign currency on a specific future date. Notice the At expiry Knock-In on the linear payoff means that the bank does not profit until spot exceeds 6. AXKOs are also possible but rare. Every TRF payoff is constructed out of these two basic building blocks. Linear or digital payoffs can be specified over any number of ranges in spot, leading to a wide array of possibilities, but in practice there are a few that stand out.

For clarity, this means that from to , the client sells USDJPY to the bank at a rate of a profit for the client. Above , the client sells twice the notional amount also at a rate of a leveraged loss for the client. Between and nothing is done and neither party benefits. This logic is flipped for the spot scenarios below , the pivot strike of the TRF. Another popular variant demonstrating this idea is the collar TRF which also has a range where neither party benefits, but with no AXKI payoff discontinuity.

It is the possibility of premature knockout or "redemption" of all remaining legs according to a preset target that make these products second-generation, and give TRFs their name. Big Figure Knockouts limit the total accumulated profit or, less frequently, loss of the client on a TRF. If we combine the above big fig KO with the first payoff in this tutorial, we have a basic TRF already in place: For each fixing in the schedule say once a month over the next year we will sell the notional amount of USDJPY at If spot stays at , this means at each fixing the client will gain 5 big figures.

A Guide to Managing Foreign Exchange Risk

This is tallied up by Middle Office and is referred to on the termsheet as Accumulated Intrinsic Value. Because we have limited the total profit to 15 big figures in the screenshot above, that means the First Exit Time of this trade is 3 months i. Because of this they are frequently used in conjunction with digital payoffs, however there is no a priori reason for this to be so. Here if spot fixes on three of the fixing dates outside the range from The last thing to note here is that we can have dual KO structures with both Range Count and Big Figure knockouts, where the TRF knocks out due to one or both of them being hit.

Worth noting here is that one of the more popular dual KO structures dealt in the bank involves only the bank's upside client's downside being knocked out if one of the KO conditions trigger, leaving only upside for the client. In this scenario the amount the client gains on the last day is calculated to be just enough to make up the stated target. For a concrete example: in the 15 big figure USDJPY strike TRF above, if spot fixed at in the first month and then again in the second month, the amount of profit paid out to the client in the second month is only 5 big figures' worth.

If the TRF is cash settled this is referred to as an "Exact" payment where we simply hand over a cash payment, however if it is physically delivered then we either adjust the strike or the notional less common of the TRF in order for the total profit to work out to 5 big figures.

Full: this is the second most popular method in which the client gets the full amount of the difference between spot and strike on the last day i. In the above example, the amount of profit paid out to the client in the second month would be 10 big figures. However subsequent payments are still knocked out. Note that if spot declined to in the second month instead, then the client would essentially be long a free strike USD call for the third month because the TRF did not knock out in the second month.

FX Options and Smile Risk

In fact, the client is long better than a free vanilla call: if the call is not in the money in the third month, it renews to the fourth month, then the fifth, then the sixth, and so on until the defined end of the TRF or until it becomes in the money, whichever comes first. This evidently has much higher value than a vanilla call. KO: The exact opposite of Full - when the target condition is reached, the TRF knocks out and the client gets nothing. In the above example, the amount of profit paid out to the client in the second month would be zero.

The bank is buying client is selling therefore the value for the bank is loaded in the back end and conversely the value of the target knockout feature is very high for the customer in the first three months quantifiable as a knockout digital. It is generally a good idea to compare TRFs to their vanilla counterparts and I have done my best to outline the similarities in my treatment above. Our complete understanding of the similarities and differences will define our ability to hedge the TRF book with first generation options.

In general every discontinuity in payoff is a source of vega and gamma just as with vanilla options, therefore, for example, pivot TRFs are better hedged with vanilla strangles rather than straddles. Vega profile of pivot TRF looks like a strangle TRF fixings and strikes are always European aka At Expiry in nature - the only thing that matters is where the fix will be on the fixing day. This also makes TRFs easier to price than some first generation exotics under monte carlo methods.

Cash settled TRFs have significant delta fixing bleeds. Because the cash settlement simulates the physically delivered forward, we have to buy or sell the delta at the fix to ensure we are fully hedged against fixing risk. We can chose to apply ramping on these digitals which decrease the payoff and PV against ourselves but also improve the risks seen when running simulations and hedging. This is similar to doing vanillla option spreads against European digitals and is pretty much the exact same philosophy. This is just a rule of thumb, with serious flaws explained below.

Based on the above it would seem that the best vanilla hedge for a TRF would just be to hedge its vega amount at the FET, as that also takes care of the gamma. We will see that this is not exactly true. I have already introduced some unique TRF risk management concepts above but for convenience I will summarize the key differences in between vanilla portfolio and TRF portfolio management here: Because of the target redemption knockout feature, TRFs generally have less optionality than their equivalent first-generation counterparts i.

TRF fixings are often done alongside vanilla option fixings but usually off of a market standard fixing page like ASFH, TKFE, ECB, or WMR, due to the need for transparency with corporate clients, instead of in the direct vanilla market where we typically determine the fix internally or with our counterparty. This causes potential fixing risk as the options we use to hedge TRFs fix at different times and different rates than the TRFs themselves, however in practice this is never an issue as we hedge internally and roll out expiring hedges.

The Deficiencies of FET as a rule of thumb. While the FET is a useful concept because it can be calculated by hand as an approximation, and the vega-gamma relationship noted above, it is important to know the problems with FET in order not to be tripped up. This is generally due to the vega sensitivity of the downward monte carlo paths bleeding into the higher spot positions in subsequent months. Vega Buckets vs Vega Bleed: This introduces a dilemma - to hedge the vega bucket risk, we really need to sell 3mth and 6mth, however if the FET assumption proves correct, and spot does not move, the TRF redeems in 2 months, and upon redemption we are left with outright vanilla positions of mths in tenor.

In short, the hedge deteriorates over time and TRF vega bleeds away faster than vanilla option vega, introducing the need to dynamically adjust the hedging portfolio. This difference in bleed speed extends to smile greeks like rega and sega. Significant Vanna. Directional TRFs the majority of non-pivot TRFs are usually dealt at a markedly improved strike for the customer compared to the regular forward this is often why they buy the TRF in the first place.

For us this means that the "option strike" has a low delta and therefore introduces a vanna on top of the vega that we get given. So the buyer TRF is expected to live to 5 months if spot drops to 98 but only expected to survive 1 month if spot rises above between the time the trade is dealt and its first fixing.

Observe below how parallel vega increases when spot goes down and how it shifts backwards in buckets when spot goes down. As they are usually some form of Exact KO and with a small notional per fix these digitals are usually small, however these KO digitals can be high when: there is a stepped payoff such as the AUDUSD TRF example above where the value for the bank is back-loaded and the upcoming fixing will determine whether or not we enter the "profit zone" for the bank there is a "full" payoff that is still live and is in the money.

The payoff discontinuities occasionally make for sizable digital risks as well.

Bibliographic Information

These are most acutely felt when AXKI payoffs are applied on daily fixing structures example below. While the KO digitals above are guaranteed to be one-time only, the AXKI digitals knock in and by definition live to see another day. In the example below we experience a daily digital where we want spot to fix above 85 the pnl works out to be about 70k per day. Part of this is a simple system issue - when running simulations the system simply bumps spot with all else constant and in doing so simply assumes that the implied vol surface will not perform, which does not realistically reflect the "true" risk of the position.

However vol surfaces do not always perform, and TRFs really do have different smile greek - to - second order greek ratios.

For illustration if we try to hedge the vega and vanna of a TRF we can do so reasonably successfully with some combination of atm and risk reversal hedges probably a better idea to do a ratio risk reversal, but you get the point. The above chart shows the vega over spot of the TRF and various hedges. The portfolio also becomes short wings despite the general design of TRFs to be long wings and tail events. Magnify these risk mismatches a thousandfold and this is representative of some of the biggest TRF portfolio management problems we have faced.

It is apparent that the differences in the ratio of second order greeks vs. If restricted to hedging TRFs with vanilla options an incomplete market with respect to the greeks we are discussing , the portfolio manager must make a conscious choice between hedging the vega and smile greeks at present spot, or hedging the vega profile over spot at the cost of assuming significant smile greek positions.

1st Edition

FX Key products Exotic Options Menu Welcome to Exotic Options Over the last couple of years options have become an important tool for investors and hedgers in the foreign exchange market. With the growing.

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