Forex Investment and Currency Trading

Tunnel

The Tunnel establishes a range within which currencies may be exchanged on a specific date in the future. The range of possible exchange rates are bound by a worst-case or “protection” rate and by a best-case or “benefit” rate. The Tunnel is structured as a combination of two out-of-the-money options, where the purchaser of the Tunnel buys an option struck at the protection rate, and sells an option struck at the maximum benefit rate. Generally, the Tunnel is structured to be zero-cost; however, the range and/or the benefit level can be improved by paying an up-front premium, also known as a “mini-pay”.

Benefit

• Provides a hedge against a USD depreciation
• The buyer has the opportunity to benefit in a USD appreciation up to the benefit rate
• There is no fee or premium associated with this contract

Drawback

• The exchange rate of the future cash flow cannot be determined until maturity, although the worst and best case rates are known
• Opportunity to benefit in USD appreciation is limited
• An obligation exists and hence market risk, if spot is above the protection strike and the underlying FX requirements change

Implied View

• Fairly confident of a USD/CAD appreciation, however require protection in the event view is wrong
• Sensitive to paying a premium. Desire to remain protected within a comfort zone