Corporate treasuries typically have limited discretion in managing market exposure and must routinely hedge foreign exchange and other identified exposures. The hedge to eliminate the risk is normally implemented shortly after a foreign exchange exposure is identified – often on the same day. The vast majority of hedges are implemented using forward rates structures because they are straight forward and provide a clear link to the underlying exposure. They also have the advantage of requiring virtually no up-front cost compared to an option trade.
But there are embedded costs of hedging using forwards. Figure 1 shows that many emerging market currencies have significant positive net carry vs. the USD embedded into their forward rates. For example, the 10% rate for the BRL means a depreciation of the BRL by 10% is required for the hedge to outperform a strategy of leaving the exposure open. And even in the absence of carry there is still an opportunity cost since an absence of risk is also an absence of opportunity. There is little carry loss in hedging THB but selling the currency forward eliminates all opportunity to benefit if the currency appreciates.
While forwards are the dominant instrument for hedging, options are another common tool as they put a limit on market exposure while allowing participation in a favourable move. The main disadvantage of options is that unlike forwards, they require upfront premium. They also are of no help in dealing with the embedded adverse carry noted above.
Risk Reversal – understanding skewed volatility
One way to get some of the benefits of an option without paying premium is using a slightly exotic tool commonly called a risk reversal. The structure consists of selling an out-of-the money option aligned with the underlying exposure (i.e. sell a call against long exposure) and using the received premium to purchase an out-of-the money option which will provide protection. If the strike on these two options were both at the forward rate then this would be equivalent to an outright forward but the risk reversal offers the opportunity to participate in a favourable move in the market up to the strike on the position sold and exposure to an adverse move but only to the strike on the position purchased. The fact that volatility for out-of-the money strikes is often skewed can make risk reversals a particularly attractive way to hedge.
For example, the USDJPY is usually skewed for USD puts (i.e., equally out-of-the money puts and calls will not have the same premium) which results in a positive potential return in using the risk-reversal (RR) instead of a forward. The RR would be applicable for an investor with short USD vs. long JPY exposure. It is constructed by selling an out-of-the money USD put and using the premium to buy a USD call. The downward skew means that the call sold will be closer-to-the money than the put purchased with the same premium. While there is exposure to a USD rally to the value of the call strike, there will be more potential gain from a USD decline to the put strike. Figure 2 shows the trade-off of the net profit and loss of the RR compared to what would be earned being long USD via a forward contract. Gains are made as the USD declines which, in this example, are capped at 9.5% when spot goes through the put strike. The RR does have exposure to USD strength but the loss is capped when spot reaches the call strike at roughly 2 percentage points less than the potential gain.
While the RR can be an attractive tool to use for hedging it is only really valid when the skew is substantial and in the appropriate direction. The RR skew for high-yield currencies is almost always for USD calls making them an unattractive instrument for hedging. At-the-money options are also unattractive because they are struck at the forward rate, so again substantial currency movement is required before the option becomes effective. For example, if a 1Y ATMF BRL call costs roughly 6% the BRL would have to decline almost 16% – the carry plus the cost of the option – before the hedged position would outperform living with the exposure doing nothing. And BRL spot would have to rally 6% – the cost of the option – before there would be a net benefit from BRL strength.
Binary Option
A European digital (or binary) option is a useful tool for countering adverse carry. This structure pays out a fixed premium at expiry if the market is past the designated option strike. The reason this structure can provide an advantage over the plain vanilla option is the differing probability structure driving the price. As noted above, the 1Y ATMF BRL call option costs roughly 6%, so the spot rate needs to depreciate at least 16% for the option to start making money. In this case, then, a $10 million call would generate a net profit of $500,000 if the market depreciated 5% beyond the forward rate. Buying a binary with a net payout amount with this strike would only cost 1.4%. Part of the reason the binary is cheaper is because it offers no protection beyond the strike price but this risk can be capped by adding a plain vanilla option with a strike yet another 5% lower which would cost about 2.4% for a total cost of about 3.8%.
The chart to the right shows that there is no free ride in this option structure. Because the upfront cost is substantially lower, the potential gain from BRL strength is bigger. But against this, while the downside is capped, the maximum potential loss is somewhat bigger than with the plain vanilla option. So the European digital option can be a useful tool for reducing upfront hedging costs when facing a high negative carry. This structure is generally going to be less attractive if the skew for downside strikes is extreme.
Conclusion
The vast majority of hedges are implemented with outright forwards. Plain vanilla options are used with less frequency to allow corporates to have some ability to benefit from a beneficial move in market prices. But, under the right circumstances, we can improve the risk profile of hedges by using exotic options such as risk reversal or digital structures. These are just two examples of the kind of opportunities that can be tapped when exotics are allowed into the corporate treasury hedging toolbox.
