There’s an instinctive appeal when it comes to simple things. And when it comes to hedging, nothing could be simpler than the humble forward contract, which makes up around 90% of FX transactions.
OTC FX Markets (BIS) - 2022
Trading Instrument | % Global Turnover |
|---|---|
FX Swaps | 51% |
FX Spot | 28% |
Outright Forwards | 15% |
Options | 4% |
Cross - Currency Swaps | 2% |
Total | 100% |
Source: BIS
The reasons are clear: no upfront costs, less analysis required and the potential for unlimited upside. However, there are definite limits to the potential of forwards contracts. And in volatile times, fluctuating currencies can leave GPs saddled with hefty MTM (Mark to Market) [the difference between the original asset price and market value at maturity] when contracts come due.
Enter the FX option, a more flexible, nuanced way to hedge against currency risk for those who want to elevate their hedging approach. Here we explore what FX options are, how they work and how you can integrate them into your strategy.
What is an FX option?
As the name suggests, an FX option is a financial derivative that provides the option (rights), but not the obligation, to buy or sell a currency pair at a set price (called the 'strike price') on or before a certain date.
In other words, it’s a contract that grants its holder the option to execute a foreign exchange transaction in the future at a pre-agreed rate.
What are the differences between options and forwards?
A forward is a simple agreement to exchange a currency on a certain date at a certain price.
Forwards are binding
They involve no upfront payment
They can be tailored to individual cases (unlike futures contracts)
Upside or downside potential is unlimited
Bought options, on the other hand, are more like insurance for your currency exposure.
Options are non-binding
You pay an upfront premium cost for the right to exchange the currencies involved
The most you stand to lose is the premium you've paid
How can options fit into an existing hedging strategy?
Both forwards and options have a valuable role to play in your hedging strategy for mitigating currency risk.
Forwards are quick and cheap to implement and suitable for stable, developed markets where currency swings are likely to be limited in scope and not lead to excessive losses.
Options offer a unique liquidity proposition: at most, you lose what you've paid. On the flip side, forwards expose you to limitless upside and downside potentials.
Options are also versatile. Besides simply purchasing an option, you can sell it. This creates a universe of intricate structures which, although more complex than forwards, have fewer liquidity demands when it comes to maturity.
Complications arise from the fact that strategies often use a combination of bought and sold options to manage risk and exposure. By blending both, GPs can build additional layers of protection against movements in the market. Examples include:
Collars: A collar involves buying a put option (securing the right to sell at a particular rate) and selling a call option (obliging the seller to sell if the rate goes above a certain level). The premium received from the sold call partially or fully offsets the cost of the bought put, thereby providing a cost-effective hedge that assures a rate within a defined range.
Participating Forwards: Buying a put option to secure a worst-case rate while simultaneously selling a call option to offset the cost. Unlike a collar, the sold call might not fully hedge the bought put, allowing participation in favorable market moves to a certain extent.
Seagulls: A combination of a collar with an additional purchased call option, which allows participation in favorable market movements beyond a certain level.
Each new option added to the strategy requires a new set of modeling and parameters, of not only how it will perform, but how its performance will affect other options within the term.
The choice of options versus forwards is often dictated by the liquidity position and technical capabilities of the fund at the time of creation – many GPs default to forwards due to a lack of visibility over the factors required to purchase an option, or to avoid the upfront payment required.
Who can sell options ?
Options can be issued by financial institutions, including major banks and brokerages. Given the complexity and specialized knowledge involved in creating options, many GPs, as well as institutions rely on specialist tools or partners.
In practice, there are only certain people licensed to give true advice on these products, and even their ability can be limited to their previous experience and their visibility in the market. The most reliable partners are those that can combine domain experience with robust technology solutions.
What are the risks and benefits of using options?
Not all options are created equal and the right choice will depend on the goals of your fund and the markets in which you operate.
Advantages of using options
Options eliminate the need for collateral or Foreign Exchange Line of Credit (FX LoC)
Using Puts, Calls, and long/short combinations, options can secure upside or neutral positions with spot.
They're ideal for hedging uncertain forecast cash flows
Disadvantages of using options
Premiums for options, paid upfront, are pricier than forwards.
Options with long durations come at a higher cost.
High volatility in the underlying asset boosts premium prices.
How do I build an option?
Building an option involves determining its components: strike price, expiration date, and the currency pair.
This can be a specialized process, leading many institutions to collaborate with platforms specializing in FX options, such as Deaglo, to ensure the structure aligns with your financial goals.
At Deaglo, we use a technology and data led approach, while collaborating closely with our customers to understand their needs.
Input Exposure Information: Define the details including maturity date, notional amount, and involved currencies.
Determine Simulation Parameters: Configure parameters like volatility levels, desired time period, and the appropriate statistical regimes.
Select Option Strategy: Choose from established strategies like Collar or Participating forwards, delve into complex products like Seagulls or TARFs, or design a custom strategy with the strategy builder.
Gauge Potential Outcomes: Run simulations to analyze and comprehend the potential performance of your strategy in varied market scenarios.
Finalize and Implement: Once convinced of the strategy's prospects and potential outcomes, proceed to execution
How do I know which option is right for me?
The market offers a plethora of structures, from Collars and Seagulls to Vanilla calls. Choosing the right one can involve significant analysis.
This is where technology platforms like Deaglo stand out, using statistical analysis – known as Monte Carlo simulations – to determine the most appropriate option for you based on analysis of a large number of random price paths for the underlying asset (in this case, currency pairs) to estimate the future value or risk of the option
Risks when buying and selling options
Traditional option pricing is a complex task —it often comes bundled with hidden costs that can catch GPs out. Such hidden charges frequently accompany the booking of an option, such as commissions, spread or margin costs, adding layers of analysis and decision making
Some options also bring their own risks, particularly highly-leveraged products such as:
TARFs (Target Redemption Forwards): These are structured products where the buyer agrees to buy a currency at a set rate.
Knock-In/Out Options: These FX options can either activate (knock-in) or become void (knock-out) upon reaching a specific currency price level.
Digital Options or Binary FX Options: Payout based on whether a predetermined condition related to currency pricing is met at expiration.
Barrier Options: These involve a barrier level, impacting their valuation and behavior depending on whether the spot FX rate surpasses this barrier.
When approaching the market, financial institutions will usually dictate the terms for the buyer, with limited scope for tailoring the choices available. However, with Deaglo’s platform, buyers can determine their desired options and the protection price they're comfortable with, ensuring alignment with their investment goals and risk appetite.
How can AI and ML be used to improve options?
Financial simulations traditionally run on historic data, which might not always capture the changeable dynamics of the financial markets. One of the most exciting aspects of AI and ML is the capability to simulate more realistic market environments by considering various market regimes.
A regime in this context refers to a certain period during which markets behave in a particular way, such as a bull market or bear market. The challenge for models lies in predicting when switches between these regimes might occur and considering them accurately in simulations.
Deaglo’s platform has already implemented ML-models in our platform to identify and adapt to different market regimes, tailoring the way we run simulations in line with customer needs.
Our algorithm identifies four distinct risk regimes in the order of Lowest to Highest-risk.
These regimes cover fat tail or black swan events that are observed in the market, based on historical data.
The performance of various hedging strategies can be tested with the regimes for a comprehensive view of the risk profile in various market environments.
By dissecting various scenarios – both unfavorable and favorable – we’re increasingly able to shed light on expected drivers and potential outcomes. This is enhanced by the ability of Large Language Models (LLMs) to extract and summarize results to drive truly effective decision-making.
If you want to find out how options could benefit your hedging strategy, why not get in touch?