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Deaglo designs options hedging strategies to protect short-term exposure

Alternative short-term hedging strategy gives PE client protection and participation on BRL 50m transaction.

Client type and solutions

An alternative FX hedging solution designed by Deaglo allowed a PE client to protect against FX losses whilst allowing them the flexibility to benefit from FX gains.

Deaglo helped the client visualize, understand and gain insight into the performance of various options hedge strategies and select the one that met their needs best.

Takeaways

  • Worked to provide a 0% initial margin on trades, freeing up critical capital.

  • Reduced the downside risk and allowed participation in the upside.

  • Designed an alternative solution to the typical use of forward contracts, which were unfavorable in this situation.

Background

An international pension fund acquired a stake in a Brazilian sanitation company, which was controlled by a Brazilian Private Equity fund, the “Client”.

The stakes sold by the Client amounted to BRL 50M (roughly $8.9M). Although the bid had already been accepted, it would only be funded 20 days later.

The Client wished to maximize the USD obtained, and manage the downside risk as the funds were going to be transferred to an offshore SPV. The risk was considerable, as USDBRL volatility was above 4%/month.

The Challenge

The main objective was to design a hedging strategy to protect the clients' participation in a BRL 50m transaction. So how did we achieve this?

Approach: 

Because the forward points weren’t favourable in this trading direction, FX option strategies were the only viable risk management method. Therefore, Deaglo modelled the following six option strategies: Seagull, 50% participating forward, Collar, forward extra, tracker forward, and tracker KO.

Deaglo then ran a simulation across many thousands of potential spot rate paths (Fig. 1) to evaluate option performance against the unhedged exposure; Deaglo employed a Monte Carlo approach to modeling the market. The period volatility modeled was 5%, with a zero skew (no market trend), and a trading spread of 20 bps.

USDBRL Simulation Path.png

Fig. 1 shows the first 50 of those paths, illustrating the variety of outcomes evaluated.  

Results:

The main objective of FX risk management was to reduce the downside risk, with the preservation of potential upside.

Thus, the performance of the forward extra and both trackers were poor enough to delete from the graph (Fig. 2). 

 

The Seagull and Collar both limited downside risk admirably, but the Collar preserved the most upside and showed the best median.

Strategy Comparison.png

Fig. 2. Strategy Comparison

Deaglo also worked on an FX credit line with a new provider for the client to execute the option. The Client was not asked to post any initial margin and had a 300K USD  threshold for variation margin. This allowed the Client to free up valuable capital and eliminated frustrating daily mark-to-market requirements.


Also, this new FX provider was able to offer a rather competitive spot rate for cross-border transactions.

Conclusion:

 

Although Forward Contracts are the most frequently cited strategy for mitigating short-term risk, it does not allow any potential participation and both the forward points curve and posting of collateral would have been a hurdle.

Options strategies are an excellent hedging alternative to mitigate short-term risk and maximize the potential for gains. Using Monte Carlo techniques to model the range of outcomes, Deaglo helped the client visualize, understand and gain insight into the performance of various options hedge strategies and select the one that met their needs best.