Foreign Currencies | Exotic Foreign-Exchange Options
Exotic Foreign-Exchange Options
“As the managing director of a tour operator, I have so far hedged my exchange-rate risk with call options. Are there more cost-effective possibilities?”
With a forex option, you have so far purchased complete hedging against exchange-rate losses. There are a number of exotic options that cost less but that also offer less than standard options. One such low-cost possibility, the “knock-out call option”, hedges against rising rates like a standard option provided the rate is above the agreed trigger. If the rate falls below the agreed limit your option immediately expires without value, but this means the rate situation looks healthier for you so you can reassess your options. So-called standard options (also known as “vanilla” options) have clearly defined characteristics (call and put, currency pair, maturity, strike price, etc). The purchaser of the option has the right to exercise the option while the seller acts as the “writer”, i.e. he has an obligation to purchase (put) or to sell (call). For many corporate clients who want to hedge currency risks, however, the premiums of “classical” options are too high. Ways of reducing the premiums were thus sought. This has given rise to “exotic” options, which have additional characteristics or restrictions. They make it possible to reduce the premium without losing sight of the objective of the hedge. The special conditions for exotic options are stipulated in an addendum to the option confirmation. Since they are usually very complex instruments that have to be calculated and monitored at considerable expense, the minimum amounts are relatively high. If no minimum amount is indicated, please ask the forex specialists. There are hardly any other transaction risks that cannot be hedged in one way or another – there is no shortage of possibilities. However, it is a good idea to clarify in each case whether it makes sense to pay a premium. Not all “exotic” options are suitable for hedging, however, and many are used for purely speculative purposes. More information on the subject can be found at www.credit-suisse.com/fx.
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Foreign Currencies | Exotic Foreign-Exchange Options
Credit Suisse offers various “exotic” options specifically for hedging purposes: Many of the following options are “pathdependent”, because key components depend on price developments during the term rather than on the market rate at maturity, as would be the case for a “normal” option.
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Knock-Out Option The knock-out option consists of a standard option (call or put) and a trigger. It expires automatically if the spot rate touches the trigger during the term. The trigger is always set out of the money. Example of a call (also known as a “down-and-out” call): USD / CHF spot Strike Trigger 1.3000 1.3250 1.2800
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Barrier options are better value for money than comparable standard options because they have a trigger and therefore expire earlier or kick in later. Recurring and therefore “predictable” payments can be hedged at low cost by means of an average-rate option. The compound option, as an “option on an option”, is particularly suitable for hedging the potential exchange-rate risk that comes with a commercial bid. Of the many other exotic options, the following are also discussed here: the lookback option for hedging exchangerate risk at the best possible rate, the quanto option for hedging economic risk, the payout option for speculative purposes, the instalment option as a special variant of the compound option, the forward-starting option for providing for favorable constellations, the cross-asset-class option for combined hedging of two different risks, and the option on outright forward if a forward contract is required at maturity.
Example of a put (also known as an “up-and-out” put): USD / CHF spot Strike Trigger 1.3000 1.2750 1.3200
Also highly popular are structured options strategies that can be designed by combining different options. For example, you can find a description of the enhanced forward and the leveraged forward on page 38. With both these strategies the client enters into forward transactions at preferential rates to the forward price, but they also entail additional risks. Barrier Options Barrier options contain a trigger in addition to the strike price. When this trigger level is reached, the option expires without value (knock-out) or it is only then activated (knock-in). Only the knock-out option is used as a hedging instrument, and in cases when there is a fear that the rate will move in the wrong direction. If it moves in the right direction, the option will expire when the trigger is activated, but this means the client can then obtain cover at a preferential rate. All other barrier options have a more speculative nature. Barrier options are subject to the following provisions: ■ Minimum amount USD 500,000 or equivalent ■ Minimum maturity 1 week ■ Currency pairs on demand
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Knock-In Option The knock-in option consists of a standard option (call or put) and a trigger. It is activated automatically if the spot rate touches the trigger during the term. The trigger is always set out of the money. Example of a call (also known as a “down-and-in” call): USD / CHF spot Strike Trigger 1.3000 1.3250 1.2800
Example of a put (also known as an “up-and-in” put): USD / CHF spot Strike Trigger 1.3000 1.2750 1.3200
Foreign Currencies | Exotic Foreign-Exchange Options
Reverse Knock-Out Option The reverse knock-out option, or RKO, consists of a standard option (call or put) and a trigger. It expires automatically if the spot rate touches the trigger during the term. The trigger is always set in the money. Example of a call (also known as a “kick-out” call): USD / CHF spot Strike Trigger 1.3000 1.3250 1.3500
Window Barrier Option With this form of barrier option the trigger only applies during a specified period. The period in question may range from a few days to almost the entire term. The greater the probability that the option will expire earlier or be activated later, the lower the premium. All barrier options can also be traded as window barrier options. This is particularly recommended if the risk of a relatively major price movement can be forecast for a specific time, e.g. in the case of elections, G7 meetings, etc. At-Expiry Barrier Option With this form of a barrier option the trigger is only active at maturity. All barrier options can also be traded as at-expiry barrier options (or barrier-at-the-end options). They are also used as part of a bandwidth option (page 36), but only for the option sold and not for the hedging component. Examples:
Example of a put (also known as a “kick-out” put): USD / CHF spot Strike Trigger 1.3000 1.2750 1.2500
Reverse Knock-In Option The reverse knock-in option consists of a standard option (call or put) and a trigger. It is activated automatically if the spot rate touches the trigger during the term. The trigger is always set in the money. Example of a call (also known as a “kick-in” call): USD / CHF spot Strike Trigger Example of a put (also known as a “kick-in” put): USD / CHF spot Strike Trigger 1.3000 1.2750 1.2500 1.3000 1.3250 1.3500
USD has risen from 1.25 to 1.40 during the term and lies at 1.35 at maturity. From the client’s perspective the situation is as follows: ■ A normal call with a strike price of 1.30 gains 5 points. ■ A call 1.30 with a knock-out at 1.20 gains 5 points. ■ A call 1.30 with a reverse knock-in at 1.40 gains 5 points. ■ A call 1.30 with reverse knock-out at 1.40 is knocked out and thus worthless. ■ A call 1.30 with at-expiry reverse knock-out at 1.40 gains 5 points, with lower costs.
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Foreign Currencies | Exotic Foreign-Exchange Options
Average-Rate Option An average-rate option (ARO) is a call or put option whose strike price is compared not with the exchange rate at maturity but with the average rate during the term. If the option is exercised, the purchaser receives the difference between the strike price and the average rate in cash. The number of rate fixings for the average can be selected (daily, weekly, monthly, or individually). If different payment flows are expected on different dates, a weighted average-rate option can be concluded which is tailored to the projected cash flows. The only restriction for average-rate options is that all details must be fixed before the transaction is concluded. An ARO may be resold at the market rate at any time. When concluding an ARO, the investor should not forget that the actual foreign currency income received must be physically sold in each case, and is not a component part of the option. If the average rate achieved from the agreed rate fixings is lower than the strike price agreed in the ARO put option, the bank will pay the difference at maturity. The ARO is appropriate for hedging budget rates if payment flows can be more or less predicted. The ARO is ideal for hedging export revenues when payments are distributed over a certain period of time. The following provisions apply for an average-rate option: ■ Minimum amount USD 5 million ■ Minimum term 2 weeks ■ Currency pairs on demand Example: The export company Schmid AG has purchased an average-rate option at the beginning of both 2002 and 2003. ■ Amount USD / CHF 6 million ■ Term 1 year ■ Strike price: 1.6250 (2002), 1.3250 (2003) ■ 12 rate fixings, at the end of each month ■ Basis for fixing: The rates of the Federal Reserve Bank of New York (as at 4 p.m.) On each rate-fixing date, our exporter sold USD 500,000 at the daily rate, thereby achieving an effective average rate of 1.5500 (2002) and 1.3416 (2003). In 2002 the profit on the ARO amounted to CHF 0.0750 per USD, so on December 31, 2002
CHF 450,000 was paid. This amount was used to offset the initially paid premium and the lower revenues from the foreign currency income arising from the export business. However, minimum revenues (strike price minus premium) were guaranteed at all times. In 2003 the export of achieved a higher rate (1.3416) than that hedged with the ARO. The ARO was therefore not used, expiring worthless. Instead, the premium had to be deducted from the higher export proceeds. Here too, the exporter was able to rely on guaranteed minimum revenues at all times. To make a true comparison, the result would have to be compared with the forward rates. Year Date of transaction Rate at end of prev. Dec. Strike price chosen for ARO Effective rate at end: January February March April May June July August September October November December Effective average 1.7119 1.7044 1.6818 1.6220 1.5623 1.4883 1.4820 1.4946 1.4938 1.4883 1.4844 1.3875 1.5500 1.3576 1.3600 1.3683 1.3618 1.3025 1.3545 1.3600 1.4005 1.3758 1.3225 1.2928 1.2423 1.3416 2002 01.01.2002 1.6840 1.6250 2003 01.01.2003 1.3875 1.3250
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Foreign Currencies | Exotic Foreign-Exchange Options
Compound Option The compound option is an option on an option. The purchaser is entitled to purchase a call option (put option) with a fixed strike price and fixed maturity at an agreed premium at a pre-determined future date. In this case, the premium at which the agreed option may be purchased at maturity is the strike price (compound strike). At maturity, the current market premium is compared with the agreed premium. If the market premium is lower than the compound strike, the client allows the option to expire; if the compound strike is lower than the market premium, the client achieves cost-effective hedging. The higher the premium the client is prepared to pay immediately, the more attractive the compound strike. However, the total premium is always more expensive than that of a “normal” option. In the best-case scenario (not exercised), the hedge works out less expensive because of the relatively small advance premium. For this reason, this option is particularly suitable for a company that cannot gauge whether or not a pending transaction (bid deadline) might subsequently entail a degree of currency risk. Example USD/ CHF call: 6-month term Strike price Premium Comparison of different compound strikes: Overall term six months, of which option is valid for three months Strike price Compound strike Advance premium Total cost upon exercise 1.3250 0.0100 0.0120 0.0220 1.3250 0.0050 0.0150 0.0200 1.3250 0.0180
Other Exotic Options Payout Options Payout options are not used for hedging exchange-rate risks but are normally used in a highly speculative manner to profit from expected price trends. They do not have a nominal amount, but involve a premium and pay out a fixed amount at maturity or when a specific condition is met. This distinguishes them from “standard” options, where the difference between the strike price and the spot rate at maturity reflects a profit (or a loss). Payout options are most suitable when used as non-matching hedges (proxy hedges). For example, if a specific exchange rate is exceeded, a company incurs losses that can be offset with a payout option. Payout options are subject to the following conditions: ■ Minimum premium CHF 5,000 ■ Minimum term 2 weeks ■ Currency pairs on demand The pre-determined amount is payable at maturity: ■ if the spot rate does not touch the trigger during the term (no-touch option); ■ if the spot rate touches the agreed trigger during the term (one-touch option); ■ if the spot rate touches one of two triggers (either side of a bandwidth) during the term (double one-touch); ■ if the spot rate does not touch either of two triggers (either side of a bandwidth) during the term (double no-touch). ■ If the spot rate at the end of the term lies either above (call) or below (put) the strike price (digital option, also known as a cash-or-nothing or binary option). The decision as to whether the trigger is touched is taken by the bank in accordance with customary industry practice and principles. Example: If a company invests CHF 10,000 in a no-touch option with a trigger at 1.48 and with a payout of 1:5, the amount paid out under the best scenario is CHF 50,000 (1.48 not touched during the maturity). In the worst case the company loses the premium of CHF 10,000 (if 1.48 was touched). With another type of pricing, the premium is expressed as a percentage of the payout amount. In this example the premium is 20 %.
An exporter who must make a bid but does not know if and when he will receive the order can achieve a good hedge with a compound option at relatively low premium costs. If he has to redeem the option, however, hedging is more expensive than with a “standard option”. In other cases, the compound option is better value for money.
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Foreign Currencies | Exotic Foreign-Exchange Options
Quanto Option The quanto option behaves like a classical option, but the payout of any profit is in a third currency (for example USD / EUR call, premiums and any profit paid out in CHF). If a Swiss company is facing Japanese competition in the US market, it is exposed to the USD /JPY rate. It can hedge its economic risk with a quanto option by purchasing a USD /JPY call option, paying the premium in CHF and having any profit paid out in CHF. The profit compensates it for worse conditions vis-à-vis its Japanese competition in the event of an isolated increase in the USD /JPY rate. Lookback Option At maturity, the lookback call option pays the difference between the strike price and the best possible spot rate at which the client could have bought during the term. The lookback put compares the strike price with the highest possible rate during the term. This option is rather more expensive than a comparable “standard” option. The client thus hedges at the best possible rate during the hedging period. This type of option can be advantageous as a precaution against more turbulent times, particularly in calm phases with low volatility. Installment Option This compound option includes several decision dates and corresponding premium payments. On each date, the purchaser of the option can decide whether he wants to pay another tranche of the premium and retain the rights to the option. All details of the option are determined in advance when the transaction is concluded. Forward-Starting Option The forward-starting option is a classical option that only kicks in on a predetermined future date. The strike price is fixed at this time. For example, it is agreed in advance that the strike price will equate to an at-the-money forward, or a delta is fixed. The maturity and volatility are also determined when the transaction is concluded. This option is attractive in the event of an extremely inverse volatility curve, i.e. if long-term volatilities are substan-
tially lower than their short-term equivalents. Companies that regularly hedge with options can provide for later hedging in the event of a favorable constellation in the volatility market. If the option is not needed, it can be re-sold at any time, possibly even at a profit. Cross-Asset-Class Option If a client has to hedge two different risks, he can combine them in such a way that the risk that has the worse performance over the term is hedged. For this purpose, he selects a cross-assetclass option that allows him to choose between two options. At maturity, he can select the variant that offers the greatest profit. Examples: Call USD / CHF and call USD / EUR (or put EUR / USD) Call GBP / CHF and put EUR / CHF Call USD / CHF and put on SMI The cross-asset-class option is less expensive than the two individual options together, but more expensive than just one option. Option on Outright Forward With this option, the purchaser obtains a forward transaction if he exercises it at maturity. With the classical option, he would receive a spot transaction and would have to conclude a swap at daily prices. If an exporter makes a bid, he does not know in advance whether he will actually need the hedge. If he receives the order, he can conclude a forward transaction and thus has a more reliable basis for calculation than a competitor with a put option. This could be advantageous in the event of a distorted interest-rate constellation.
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