Published: December 31, 2005
Carlo Scotto, derivatives expert at SuperDerivatives and Shant Movsesian, currency strategist at 4CastWeb, share their views on current market trends and corporate hedging approaches
The markets have changed significantly since 2008, triggering a much higher level of uncertainty, more risk factors to consider, and an ever-changing regulatory environment. There is an increasing board level attention on corporate treasuries to adopt a more optimal approach to risk management.
Graph 1: 1 year implied ATM volatility for EUR/USD 2009-2013
Let’s take an example of a treasurer who needs to sell USD and buy EUR in six months. After a historical analysis of the EUR/USD and in light of on-going turbulence in the Eurozone, he concludes that the euro will continue downwards.
Buying a Risk Reversal, or collar is a simple option, allowing a treasurer to set the strike of the protection leg at 2% (250 pips) worse than the spot rate and solve for the strike of the financing euro put for zero cost, around 230 pips lower than the forward rate. This gives protection to buy euros at 250 pips higher than the prevailing spot rate in the worst case scenario, while benefitting from any depreciation in the Euro by up to 230 pips.
This ‘symmetry’ of gain and loss is typical for Risk Reversals when there aren’t any large volatility skews in one particular direction. However, other strategies offer much greater potential upside in return for the 250 pips of protection.
Two popular structures which attempt to minimise the risk of this downside occurring attach a condition to the short leg, whereby the sold leg will only exist if a pre-defined “knock in” barrier is breached. The Forward Extra (or Forward Plus) entails buying a call option and selling a put option at the same time with the same strike, and a knock-in barrier set somewhere below the strike.
An American style barrier is “knocked in” if breached at any time, while a European style barrier is only triggered if it fixes below the barrier on expiry.
The American Forward Extra places a barrier on the short put at approximately 1,600 pips below the opening spot, and the European Forward Extra has a barrier around 1,000 pips below the same spot. The 250 pips of protection remains.
Based on a reference spot of 1.25, all three structures provide protection against the EUR/USD rising above 1.2750 but offer different potential benefits should this protection not be needed. The Risk Reversal enables the exporter to benefit if the euro falls to 1.2270. The Forward Extra with an American barrier gives the freedom to buy euros as the market falls so long as 1.09 is never touched. The European barrier will only force the exporter to buy at 1.2750 if the euro finishes below 1.15 on expiry, regardless of its path up to that point.
At first glance, both Forward Extras appear attractive – instead of the payoff symmetry of the Risk Reversal, the exporter has a 1:6 risk/reward ratio in the American Forward Extra (1:4 in the European example) between the protection given up should the euro rise and the potential benefit should the euro fall.[[[PAGE]]]
Backtesting the historical hit ratio allows treasurers to assess how often the barriers are likely to have been hit. Furthermore, explicit testing can also be run on the net performance of each structure (including the exposure) to confirm whether the strategy would’ve performed best historically as a hedge.
Backtesting structures over a historical period that mimics the exporter’s anticipation of what is likely to happen is essential in order to get an accurate assessment of the risks involved.
Graph 2. Backtesting and event probablity analysis
For the three-month period up to September 2011, the euro strengthened and all three structures lost 2% compared to spot. Then the euro weakened and each structure started to provide significant benefits, as the holder could have bought euros at the reduced rate.
The vertical downward spikes between January and March 2012 occurred when the American and/or European barriers were triggered. Despite a sharp fall in the euro, the structure holder would be committed to buying euros at a strike of 2% above the opening spot.
Backtesting tools can be used to highlight the most efficient and suitable combination of strike and trigger and determine the optimal combination of risk and reward.
1. Identify, quantify and manage risks: Some risks are obvious, such as exposure to floating rates while cash flow exposures might require a constant rebalancing of the overall derivatives position;
2. Shop for prices: banks are aware of the direction of the trade you wish to enter, skewing the quotes towards the bid or the offer side;
3. Counterparty credit risk is risk factor: dealing with multiple banks allow for credit exposure diversification and frees up additional notional for new hedges;
4. Forwards are not always the best hedge: collar-like structures, combination of puts and calls where the financing leg offsets the cost of the insurance bought (zero cost), are equally attractive hedges which could result in better protection at a more favorable price;
5. Hedge Accounting helps protect balance sheets from unexpected P&L volatility; IASB is proposing a new hedge accounting framework more closely aligned with the markets and corporate risk management practices. Consult a reputable vendor as well as your auditor and apply to be an early adopter;
6. CVA: Corporate CVA methodologies differ from how banks account for their CVA charges. Reputable vendors offer tools to compute credit adjustments.
7. Align your Treasury Management System with regulatory changes.
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