By Frances Coppola
This article assumes familiarity with how options work, and option terminology is used throughout. Readers who are unfamiliar with options may wish to review the first article in this series before reading further.
In some types of options, the premium is reduced or eliminated because the structure of the contract enables the seller to share in the benefits of favorable exchange rate movements. 1
In a participation forward, the premium is reduced or eliminated but if the option expires out-of-the-money the buyer is obliged to buy a percentage of the funds at the “protection rate” rather than at the prevailing spot rate. We can regard this as a combination of a vanilla call option and an outright currency forward contract at the protection rate. Because only part of the contract is at a fixed rate, FX losses due to a business being unable to take advantage of favorable exchange rate movements are likely to be lower than they would be from hedging entirely with a forward contract
A forex collar has both a protection rate and a “participation rate”: the buyer is protected from losses on adverse exchange rate movements, but the seller participates in gains on favorable movements. Alternatively, a collar can be viewed as an option combination: a purchased put and a written call, or a purchased call and a written put. The strike price of the purchased option is the protection rate and the strike price of the written option is the participation rate.2
For example, suppose an Australian exporter agrees to sell iron ore worth US$1,000,000 at a date nine months in the future, with payment in U.S. dollars. The exporter wishes to avoid losses in Australian dollars should the AUD-USD exchange rate rise in that time. But he would rather accept less benefit if the AUD-USD exchange rate falls than pay a premium for a vanilla put option which he would lose if the option expired out-of-the-money. So he buys an AUD-USD call option with a strike price of 0.79 and simultaneously writes an AUD-USD put option with a strike price of 0.75.
This structure is a collar: the strike price of the call option is the “protection rate,” and the strike price of the put option is the “participation rate.” If the AUD-USD exchange rate rises to 0.8, he exercises his option to buy Australian dollars at 0.79. But if the AUD-USD exchange rate falls to 0.74, he must buy Australian dollars at the participation rate of 0.75, not at the spot price.
There is no premium for the AUD call, so if it expires out-of-the-money the company has lost nothing. But if the AUD-USD exchange rate drops enough to trigger the AUD put, the company will lose the difference between the spot price and the participation rate. This is a “notional” loss: the company has not paid out any more money, it has simply bought less AUD for the same amount of USD, but this means that its profit in AUD on the iron ore export is lower. It is a direct hit to the company’s bottom line due to its FX exposure.
Collars can be effective low-cost hedges if the currency is relatively stable, but if the currency is volatile, holders of collars may potentially incur large notional losses from favorable exchange rate moves.
Another way of reducing the premium cost while maintaining an effective hedge is to set conditions for the activation of the option. Barrier options are one way of doing this. There are two basic types of barrier options:
Note that these options are always European options, since the flexible exercise date of an American option is not compatible with knock-in or knock-out triggers
In the context of the earlier collar example, instead of buying an AUD-USD collar with protection rate 0.79 and participation rate 0.75, the company can purchase an AUD-USD call option with strike price 0.79 and write a down-and-in AUD-USD put option with trigger at 0.72 and strike at 0.75. If the AUD-USD exchange rate rises to 0.8, the company will exercise the call option and buy Australian dollars at 0.79, just as it would in a collar. But what happens should the exchange rate fall is more complicated. The call option expires out-of-the-money, but there are two alternatives for the put option:
Thus, using a barrier option instead of a simple collar can enable a company to eliminate the option premium while limiting notional losses from favorable exchange rate moves.
Barrier options can be single or double trigger. In a double trigger, a trigger rate is set on both sides of the structure. So, for example, in our example above, a cost-conscious company could set an up-and-in trigger at 0.82 on the call option as well as down-and-in at 0.72 on the put option. Neither option would activate until one or the other of the triggers is reached. Such a structure would not eliminate all FX risk, but would provide low-cost protection against unexpected currency volatility.
Exotic options typically put the company’s capital at some risk, and for this reason they are not suitable for all businesses. But for some businesses they can provide effective FX hedging at lower cost than simple forward contracts and vanilla forex options.
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.
1. “FX Options for Business Transactions,” Mitch Wells via LinkedIn; https://www.linkedin.com/pulse/fx-options-business-transactions-mitch-wells
2. “Collar options,” Smart Currency Business; https://www.smartcurrencybusiness.com/services/options/collar-options/
3. “Barrier Option,” Investopedia; http://www.investopedia.com/terms/b/barrieroption.asp
4.Exotic Options and Hybrids: a guide to structuring, pricing and trading, Bouzoubaa & Osseiran, Wiley; http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470688033.html