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The use of exotic forex options can help reduce hedging costs and manage complex FX risks

Using Exotic Forex Option Structures for FX Risk ManagementARTICLE

By Frances Coppola

We have previously discussed how “plain vanilla” forex options, as well as forward contracts, can help businesses to hedge their FX exposure. Readers who don't already understand the basics of how FX options work may wish to review that article before reading further.

Many businesses find their FX risk management needs can be fully met with currency forwards and vanilla forex options. However, vanilla options can be costly. The option’s cost, or “premium,” must be paid up front, and if the option subsequently expires unexercised the premium is lost. Some businesses, too, have complex FX risk management needs requiring more sophisticated solutions.

Luckily for such businesses, forex options come in a multitude of variations. There are forex options to suit every FX risk management need.

What are “Exotic” Forex Options, and Why Do They Exist?

So-called “exotic options” have non-standard features that enable them to be tailored to individual risk management needs. They are always traded over-the-counter, i.e. directly with a counterparty rather than on a recognized exchange, though they may be cleared by a central counterparty (CCP). They can be complex, involving multiple option contracts and sometimes other instruments as well, such as forward contracts.

Further, exotic option structures can involve a business selling options as well as buying them. Option contracts are in many ways similar to insurance contracts; so in options parlance, selling an option is known as “writing” it, just as selling insurance is called “writing” (a policy). As with an insurance contract, the potential reward from a written option is limited, while the potential downside loss is unlimited: unlike the insurance world, there is no reinsurance market to enable writers of options to “lay off” risk they don’t wish to take. By itself, therefore, writing an option is a risky strategy. However, carefully constructed exotic option structures incorporating written options can provide businesses with effective low-cost hedges.

Writing an option is, essentially, taking a “short” position in that option, while purchasing an option is taking a “long” position. Since taking a short position (an obligation to supply a financial instrument that you do not at present have) is regarded as speculation, written options are not regarded as hedging products in international accounting standards (IAS 39/IFRS 9). Written options in hedging structures must therefore be revalued to market value (“marked to market”) daily. They may also require initial and daily variation margin to be posted if they are cleared through a CCP.

Some types of exotic options restrict exercise dates. The lowest-cost option is a European option, which can only be exercised on its expiry date. But if more flexibility is needed, a Bermuda option can be exercised on specific dates ahead of its expiry date. It is a half-way house between a European option and an American option, which can be exercised at any time before its expiry date. Premiums increase proportionally to flexibility.

Exotic options can also be leveraged. Leverage, in financial markets, means the practice of using financial instruments (including derivative products such as options) to increase the return on an investment.1 In the case of a leveraged option, “leverage” refers to the practice of multiplying the option amount. For example, if a purchased 2x leveraged GBP-USD call option expires in-the-money, the purchaser will be required to buy twice the quantity of British pounds than the option amount. As every FX transaction involves both buying and selling currency, this means the purchaser is also required to sell twice the quantity of U.S. dollars. The result is that the purchaser’s sterling position is longer and the U.S. dollar position shorter than it would be for an unleveraged option of the same value. A leveraged option is thus a riskier transaction than an equivalent plain vanilla option.

Forex options differ from insurance policies in that risk can never be fully eliminated. They can be used successfully to hedge FX exposures, but there are always implied risks. Before we proceed to discuss more complex hedging strategies and exotic options, therefore, let’s look at how those implied risks can be identified and managed.

Understanding and Managing Implied Risks When Using Forex Options

All FX transactions involve the sale of one currency and the purchase of another. Thus, when a business purchases a vanilla option to hedge FX risk on one side of a currency pair, it is also implicitly writing an option on the other side of the pair.

For example, suppose a British exporter is anticipating a payment of $100,000 from a U.S. company in three months’ time. It wishes to protect itself against the possibility that the British pound will rise against the U.S. dollar in the interim. But it also wishes to benefit from any movement in the opposite direction. So, it purchases a three-month European GBP-USD call option at-the-money. This gives it the protection it wants while allowing it to benefit from favorable exchange rate movements.

But this is not a risk-free position. To exercise its call option, the British company must supply the agreed quantity of U.S. dollars. Thus, the British company has implicitly written a three-month European GBP-USD put option at-the-money. Currently, it doesn’t have those dollars. This is a “short” position. Being short is, by definition, a speculative position. All forex option hedges implicitly involve a company taking a speculative position in the opposite direction from the hedge. This differs from the “short” side of a forward contract because unlike an option, an outright forward contract is not subject to daily market price fluctuations. 2

To be fully hedged, therefore, the company needs to cover its exposure with an offsetting long USD position. It could achieve this with an outright forward contract to buy USD in three months’ time, but this of course would leave it obliged to buy USD it doesn’t need if the supplier pays up on time. Or it could maintain sufficient USD cash reserves from previous sales to cover its position, though this could cause it cash flow problems if the funds were effectively tied up for months. Alternatively, it could arrange a precautionary facility to borrow USD if necessary, though this might involve pledging collateral (and thus putting business capital at risk). All these alternatives incur cost, so the company would need to consider whether the risk justifies the cost of hedging the USD position.

The Takeaway

Using exotic options as part of an FX risk management strategy can help businesses to keep hedging costs down and manage complex risks effectively. However, using options to hedge FX exposure does not eliminate risk, it merely changes its nature. Identifying and managing such “implied” risks is a key part of any FX risk management strategy.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Leverage,” Investopedia http://www.investopedia.com/terms/l/leverage.asp
2. “Deconstructing Myths About Foreign Exchange Options,” Giddy; http://people.stern.nyu.edu/igiddy/options.htm

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