Forex Investment and Currency Trading

Put-Call Parity

With same strike: Call – Put = Forward

Example:

• Long 1-Month USD Call 120 on 10 Million = Long 10 Million USD at 1-Month Forward Rate 120 + Long 1-Month USD Put 120 on 10 Million JPY

Put-Call Parity in Practice

• USDJPY Spot is 121.20. A 1-month USD Call 123.25 is a 30 delta. What is the delta of a 123.25 Put?
• The Call trades at 9.3% vol. What is the volatility price of the Put, same strike?
• Spot is 121.20. 1-month Forward is 121.45. The 123.25 is worth 63 USD pips. What is the value of the 123.25 Put?
• What are the Time and Intrinsic Value of these Calls and Puts?

ATMS Vanilla

• An ATMS option (an option whose strike is the spot at the moment of trading the option) exemplifies a very classic view: to protect the current spot level from any future adverse moves

Example:

• Company’s budget rate for USDJPY is 120, but spot is 124. Company can buy an ATMS option for the hedge
• If spot falls, the company can buy at the lower rate and disregard the option
• If spot rises, the company already locked in the worse case rate at 124

ATMF Vanilla

• In an At-the-money-forward option, the strike is equal to the forward rate at the time of trading the option. The tenor of the reference forward rate is equal to the tenor of the exposure to be protected

• This choice of strike is classic in that it gives a 50% mathematical probability that the option will be exercised. It also offers an easy comparison with a forward hedge, as the strike is equal to the market forward rate
• It is suitable for corporations that want to hedge against any outcome that is worse than the current market implies. On the downside, the option is sometimes expensive. Sometimes the strike is better than the at-the-money-spot strike (the case for a USD call), so the option is more expensive than the ATMS, and sometimes it is worse than the ATMS strike (the case for a USD put), so the option is cheaper than the ATMS option. It will depend on the forward points for each specific currency pair.

Low Delta Options

• In an out-of-the-money option, the strike is worse than for an ATMF option (in case of a USD call, the strike is higher), so the protection kicks-in after some losses are incurred

• On the other hand, the premium is reduced. Additionally, if a protection only for the 20% worst-case scenario is needed, then a 20%-delta option should be purchased: this is an out-of-the-money option, and it costs much less than an ATMF option

Examples:

• The company believes that Yen will strengthen, and does not want to spend premium to purchase full protection
• The company only needs to protect against extreme moves to the upside
• The company has a limited budget to spend for option premiums

Collar / Risk Reversal

A Collar or Risk Reversal is the most popular option combination and is built on one basic concept: “Let’s sell some upside to protect our downside!” The hedger sells an out-of-the-money call to finance the purchase of a out-of-the-money put. The corporate is exposed to currency fluctuations between the two strike levels.

Although this strategy is often assembled to have no upfront premium, with a small upfront cost, the put strike may be placed closer to the forward level to achieve better protection. The distance between the strikes depends on the risk profile of the hedger.

The collar offers straight forward risk-reward dynamics that allow for great flexibility and some degree of customization.

For example, suppose that a corporation has a policy of X% minimum hedging, but it also is not approved to spend premium, or significantly restricted in the ability to spend premium. In this case a collar would allow them to meet the X% hedging ratio without spending premium.

P/L Profile of the Collar

P/L Profile of a Collar – Hedging a Long Exposure

Suitable for:
Corporate who seeks full downside probability with a zero-cost structure.

Structure:
Long Put / Short Call

Premium:
Zero Cost

Volatility:
Neutral

Accounting:
This structure is usually viewed favorably by auditors for hedge accounting (provided conditions in relevant accounting standards are met)

Interpreting Risk Reversals

• Because Risk Reversals measure the price difference between OTM Calls and Puts, they are often interpreted as the markets directional view
• This is wrong!
• They reflect the expected move in implied vol given a move in spot
• The higher the Risk Reversals’ value, the more sensitive the implied vol to spot movements
• It has been empirically demonstrated that Risk Reversals don’t have any directional predictive value on the underlying
• Nonetheless, company can use the Risk Reversal to their advantage: for zero cost, you might expect that you can buy a 30% delta USD call / JPY put and sell a 30% delta USD put / JPY call. But the Risk Reversal is bid for USD puts: this means that the option you sell is more valuable than the option you buy
• The bank has to compensate you for that. This is generally done by giving you a 32% delta USD call in exchange for a 30% delta USD put
• Therefore, your asset has a higher probability of being exercised than your liability does

Participating Forward

A Participating Forward is the combination of a purchased put option and a sold call option for a smaller amount (i.e.. 50% of put option) with the same strike and maturity.

The Participating Forward offers both protection against adverse FX movements AND the prospect of participating in favorable changes to a certain extent. This structure is suitable for companies that do not want to pay a premium to buy options in order to hedge their FX risk, but prefer zero-cost structures that give some upside potential.

The participation ratio depends on the chosen notional amounts of the options relative to each other. This relationship works as a trade-off and is a function of the company’s risk / reward profile: for corporations with higher risk tolerance, the put strike can be placed further out-of-the-money, allowing for upside participation, and vice-versa.

There is a trade-off between strike and participation rate: to have a higher participation rate, the strike needs to be lower for the structure to still achieve zero-cost.

P/L Profile of the Participating Forward

P/L Profile of a Participating Forward – Hedging a Long Exposure

Suitable for:
Full downside protection strategy that also allows for upside participation.

Structure:
Long Out-of-the-money Put / Short Call (for smaller amount)

Premium
Zero Cost

Volatility
Long

Accounting
This structure is usually viewed favorably by auditors for hedge accounting (Provided conditions in relevant accounting standards are met)