According to the most recent Bank of International Settlements (BIS) survey, published in December 2011, and based on statistics as at 30 June 2011, the foreign exchange (FX) market has shown an overall annual increase of 12% in notional amounts traded. In addition, there has been a 26% increase in FX options traded under one year maturity, coupled with a sharp decline of 48% in the number of long-term FX derivatives contract (five years and traded longer). The change could reflect more conservative counterparty risk management and the application of credit value adjustment (CVA).
Overall, from December 2010 to June 2011 FX options volumes increased by 12.5%; interestingly a proportionally larger increase than that for forwards and FX swaps. This could reflect the lower volatility experienced over the period that made the purchase of options cheaper, or an increased appetite for trading non-linear products.
Figure 1: Trends in FX Over-the-counter (OTC) Trading
Figure 2: EUR/USD Spot Rate Chart
Given the market volatility and the euro’s weakness since summer 2011, for corporates with multi-currency exposures the need to hedge foreign-denominated receivables has never more timely or prudent in effectively managing the balance sheet. By suggesting potential advanced hedging strategies, this article aims to demonstrate a cost-effective way for corporate treasurers to mitigate FX risks.
Google as a Business Case
To illustrate the available hedging options, Google will be used as an example of a US corporation with multinational activity, which generates multi-currency underlying assets’ exposure with a significant dollar cost base and subject to significant FX rates fluctuations.
This business case will examine various advanced FX hedging strategies, and their impact had Google deployed them within this time period. It commences with single asset strategies such as average rate options, partial barrier forward, compound options and gated knock out.
Google’s activity generates multi-currency exposure, which would suggest a multi-asset hedging strategy as this has proved efficient and cost-effective. Finally, it examines the multi-asset strategies of cross-asset knock out and a basket option.
An explanation and analysis of each structure compares their respective payoffs and costs.
In financial reports, specifically its SEC 10-K Form of December 2011 , Google disclosed the usage of FX derivatives used to hedge its exposures during 2011:
- US$3.8bn versus euro.
- US$2.2bn versus British pound.
- US$0.5bn versus Canadian dollar.
(Note: The option classes were not disclosed in the report)
Google details its scenario analysis policy by applying 20% shifts up and down, in euro/US dollar, pound/US dollar and US dollar/Canadian dollar respective spot rates. The results, in millions of dollars, are shown in Figure 3, derived from the financial reports of Google in December 2011.
Figure 3: Google: Scenario Analysis Results (December 2011)
As seen from the table, when a 20% shift is applied Google is fully hedged against both scenarios. A 20% US dollar strengthening, which is the main concern and reason for applying the hedging policy, would generate a positive income of almost US$1bn, while a 20% weakening of the currency would have a relatively minor impact on Google’s net income.
Potential Hedging Strategies that Google May Use to Address FX Exposure
This section suggests the different hedging strategies that may be used by Google to address its FX exposures.
Any prudent treasurer aims to mitigate currency risk on an on-going basis. For Google, given its reported exposure to the weakening euro, there is an immediate requirement to hedge euro receivables. The group has the following options for hedging:
- Enter a forward deal and lock its hedging rate.
- Purchase a vanilla option.
- Purchase a mixture of vanilla and exotic options.
- Enter single and multi-asset exotic strategies.
The market rates used across the pricing exercise were as follows:
- Trade date: 3 April.
- Spot rate: 1.3354.
- Forward points: 0.0015.
- Volatility structure:
o ATM Vol 10.70.
o 25D Risk Reversal 2.05.
o 25D Butterfly 0.4.
For simplicity we priced six month contracts, for a notional amount of US$100m with a strike price of 1.3200.
Google entering a vanilla option
Google buys a euro put/US dollar call option where the strike price is set at 1.3200. As a buyer of this option, the company would pay a premium of €1.95m.
Google entering into exotic options strategies
In the average rate (Asian) options strategy, the buyer purchases a euro put/US dollar call option, struck at 1.3200 with monthly fixings, which would expire in six months from the trade date – i.e. 3 October for a premium of €950,000. The premium for this option is significantly lower than that for the equivalent vanilla option of €1.95m. The fixing source has to be agreed upon inception (examples: European Central Bank (ECB) fixing published 14:15, Frankfurt, or WMR spot fix).
The payoff of this strategy would be as follows (upon expiry date):
- If the average of the sampled rates is below 1.3200 then the seller of the option would pay Google, as buyer, a cash amount based on: 100,000,000*(average-strike price)/strike price.
- If the average is above 1.3200 then no payments would be made.
- If the euro weakens as of inception most, or all, fixings would be ‘in the money’ and the option would generate a positive cash flow for the buyer.
- If the euro strengthens against the dollar and never crosses the strike price, the option would expire worthless and Google would buy its dollars in the market place at the prevailing market rate(s).
- However, if the euro/US dollar spot rate hovers above the strike price during the life-time of the option, and just towards the expiry weakens violently and crosses the strike price, then Google might be left un-hedged as the option might expire out of the money (OTM) and the average of fixing rates would be above 1.3200.
- Therefore, it is recommended in such cases, to sell a proportional amount around each fixing date for OTM fixings (sell 1/6 of US$100m at prevailing market rate).
- These options are typically used to hedge recurring cash flow exposures.
Partial Barrier Forward
This strategy is composed of the following two options: the buyer buys a put euro/call US dollar vanilla option at a strike price of 1.3200 and sells a call euro/put US dollar partial barrier option at a strike price of 1.3200, with a knock in trigger set at 1.3535.
The sold option would only be activated if the market trades at 1.3535 or above between the dates of 3 April and 3 May.
The cost of this strategy is zero, as the premiums of both options offset each other.
The payoff of this strategy would be as follows:
- If the market trades below 1.3200 at expiry the vanilla option, bought by Google, would be exercised.
- If the market trades above 1.3200 at expiry and has traded at 1.3535, or above, between 3 April and 3 May the partial barrier option would be exercised and Google would sell its euros at the rate of 1.3200. The bank, as the buyer of this option, would exercise this call euro option.
- Otherwise, both options would lapse and Google would buy dollars at the prevailing market rate, which would be higher than 1.3200.
- Google is fully protected below a spot rate of 1.3200, as it would exercise the put euro option if the market trades below 1.3200 at expiry. This is the worst-case scenario.
- If the trigger is met during the ‘activation window’ the best-case rate would be 1.3200; one of the two options would be exercised.
- If the trigger is not met then there is an unlimited upside for Google and it would end up selling its euros at the prevailing market rate, the true best-case scenario.
- This strategy was structured at a zero initial cost.
Using this option, the buyer holds a compound option at a strike price of 1.3200. The buyer has the right, in three months, to buy a vanilla option (put euro/call US dollar struck at 1.3200) that would expire in six months from now. Hence, by purchasing the compound option the buyer pays an initial premium of €920,000 upfront, but in case the compound option is exercised an additional premium of €1.5m would have to be paid to the seller.
The payoff for this strategy would be as follows:
- The buyer exercised the compound option and entered a vanilla option transaction:
1. In six months the market trades below 1.3200 and the buyer would exercise the vanilla option.
2. In six months the market trades above 1.3200, the option lapses and Google would sell its euros at the prevailing market rate.
- The buyer opted not to exercise the compound option. In three months, the buyer would decide on a new hedging strategy to apply.
- The buyer has the right to buy a vanilla option on a future date (three months), at a given price of €1.5m.
- The sum of both premiums, of €2.42m, is higher than the premium of the equivalent vanilla option.
- The buyer would choose to exercise the compound option and buy the vanilla option in three months only if it would be cheaper than the prevailing price of an equivalent vanilla option in three months (costing more than €1.5m).
- The buyer pays a lower premium at inception.
- Additional flexibility in hedging and the ability to adjust the hedging strategy in three months’ time; hence the higher overall premium to be paid in the case of the compound option being exercised.
- If the euro weakens significantly below 1.3200 from inception onwards, then it is most likely that hedging using a vanilla option would have been more cost-effective.
- If the euro strengthens significantly, then using a compound option would have entailed a lower hedging cost; a lower premium for an option that would lapse.
Use Case 2: Compound Option
Google is to participate in a tender in euro land. In this particular case, the company wishes to hedge an uncertain FX risk that would persist only if it wins the tender. As in the previous use case, its receivables would be dominated in euros and an underlying exposure would be generated. If it loses the tender, there would be no FX risk. So Google wishes to hedge this potential FX exposure at minimal cost. Instead of buying a vanilla option, the company would be buying a compound option.
Gated Knock Out
Google buys a put euro/call US dollar option with a strike price of 1.3200 and a knock trigger set at 1.3600, for a premium of €1.19m.
Every day the euro/US dollar spot rate is observed, and for as long as 1.3600 level doesn’t trade Google would accumulate a proportion of the notional amount (n/N * US$100m). As an example, if in three months precisely the market trades at 1.3600 the accumulated amount would be US$50m.
Potential scenarios at expiry:
- The market has traded below 1.3200; Google will exercise the option.
- The market has traded above 1.3200 at expiry; Google will let its option lapse and sell its euros at the prevailing market price.
- If the market has traded at 1.3600, then the option is considered to be knocked out and Google can re-hedge the remaining balance, or sell its euros at a higher rate of at least 1.3600; a superior rate as opposed to the forward rate at inception.
Using this strategy, Google would be buying a fade-in option as follows:
- Put euro/call US dollar, strike price 1.3200.
- Knock out and fade-in level set both at 1.3600.
- The fade-in level is observed daily, and used to determine the notional amount.
Google is fully hedged as long as the market doesn’t trade at 1.3600. If the market trades below 1.3200 at expiry, then the option would be exercised. However, if at expiry the market trades above 1.3200, the option would lapse and Google would have to sell its euros at the prevailing market rate.
This section considers the usage of two multi-asset strategies: cross asset knock out and basket options.
1. Cross-asset knock out
Google is buying a put euro/call US dollar option, struck at 1.3200 that would knock out only if the pound/US dollar spot rate trades above 1.7000, which compares with a rate of 1.6010 as on April 3rd. The cost of this option is €1.70m. As this is a multi-underlying assets structure, it is necessary to observe the correlation of these two underlying assets; estimated at 0.7 as this option was priced.
If the market trades below 1.3200 at expiry and the pound/US dollar spot rate never traded at 1.7000 or above, the option would be exercised. If the market trades above 1.3200 at expiry the option would lapse, and Google would buy its dollars at the prevailing market rate.
If the pound/US dollar trades at 1.7000 or above, the option would be knocked out and Google would have to apply an additional hedging strategy.
- The premium for this option is cheaper than the premium of the equivalent vanilla option.
- As the two underlying assets are positively correlated (0.7) we can assume that as pound/US dollar moves higher so would the euro/US dollar rate, provided that the correlation between the two assets doesn’t become negative.
- The barrier is set as a natural hedge, so if the pound/US dollar spot rate is higher Google would receive more dollars for its sterling exposure.
- The initial premium would have been lower if the correlation between two underlying assets were lower as well.
2. Basket options
- Google buys an option that would give it the right to convert euros, pounds and Canadian dollars to US$100m (put basket, call US dollar).
- The weights of the constituents of this basket are set according to Google’s exposure (58% euro, 34% pound, and 8% Canadian dollar).
- The strike price is a weighted average of the current respective spot levels normalised to 1.
- The cost of this basket option is €1.74m.
- The initial premium is lower as compared to purchasing three respective options; provided that the three assets are not fully correlated.
- This option offers an effective hedge, as Google is locking its dollar amount and is indifferent to fluctuations between the assets that compose the basket.
- If this option is exercised then Google will have to buy dollars at the respective prevailing spot rates. The cash flow received from the seller of the option at expiry will compensate forthe conversion at less favourable rates.
This article has discussed various hedging strategies: single asset (average rate options, partial barrier forward, compound option and gated knock out) as well as multi-asset strategies (cross-asset knock out and a basket option), in each case analysing the strategy’s respective payoffs and the advantages. The cost of the options varies; in all cases but one (compound option, when exercised) the suggested strategies cost less than an equivalent vanilla option. Each option has a unique profile that could be used in an adequate use case (exposure) according to the hedging policy of the firm.
In hindsight, the most effective strategy would have been entering a partial barrier at a zero cost. The reason being that the sold option-partial barrier call euro option would have lapsed and Google would have been long a vanilla put euro option, struck 1.3200 purchased at a zero cost.
Figure 4 summarises the strategies suggested, as well as a target redemption forward for reference.
Figure 4: Summary of Suggested Strategies
The unprecedented levels of volatility experienced over the past two years, coupled with the high level of uncertainty, have been drivers for adopting a prudent approach to managing FX exposures. When deciding and implementing a hedging programme one must take into account the historical and projected underlying prices fluctuations, examine and select the most suitable hedging strategies, as well as running the selected programme through various potential market scenarios and determine its efficiency. Decision support systems to assist with managing the hedging process are readily available.
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