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Risk Management

Big FX Decisions: Options and Forwards and When?

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April 05, 2017

Recent volatility has FX managers weighing the right time to use options and forwards.

Foreign currencyThe age of President Trump has ushered forth foreign-exchange volatility in a variety of different flavors. This has revived enduring questions for corporate treasury’s FX managers, for instance, when is it most appropriate to use options, often in combination with forward contracts, and when should they pull the trigger?

Several participants at the Neu Group’s recent Foreign Exchange Managers’ Peer Group (FXMPG) group acknowledged no budget for single call or put options, whose premiums enable companies to hedge one side of a risk exposure, unlike linear forward contracts’ that provide symmetrical gains or losses, depending on which way the currency swings. With options, hedgers must explain why paying those premiums is important, even though a misplaced forward can result in more significant losses.

“The worst situation you can be in is hedging a risk that didn’t occur, and there’s a loss,” said Peter Seward, vice president of product strategy at Reval. “Because firstly, you’re going to have to explain the P&L volatility, and then explain why you hedged something that didn’t occur.”

For the FX managers who could use options, a common challenge was simply figuring out when. Several said their companies only use the instruments to hedge specific risks. One member stationed at his company’s head office reluctantly hedged pound sterling (GBP) leading up to the Brexit vote on the London office’s advice, and the bet paid off. Another noted using the rich premiums from selling options to fund paying forward points in Brazil.

A different member noted a “strong view from management” recently that certain African currencies will almost certainly continue depreciating, and so treasury has been taxed with exploring the incorporation of 25% to 30% of its balance sheet hedging program to long-term hedges using options. “The question is why use options over forwards?” he asked, adding, “First, you must have a view, and second is you must cover the cost.”

Taking a view on what’s likely to happen in the future is problematic for many companies, whose C-Suite would prefer a more objective and systematic approach—almost a platform of hedging strategies that would be automatically triggered as economic and financial conditions changed. A few FXMPG members noted banks marketing “dynamic” hedging strategies, which use several factors such as volatility and carry to determine which type of hedging instrument to choose.

“We did back-testing going back 10 years and didn’t find a big benefit to that kind of rules-based approach,” one participant said. “Now we’re trying to go back to options again to find a strategy that would benefit us, and we’ve come up with different combinations of options and forwards for different scenarios. But we struggle with when to pull the trigger; when we should start buying the options.”

Mr. Seward noted that corporates may be increasing the use of options if their exposures are becoming more uncertain, as the risk of global events such as a trade war and greater emerging-market volatility mount. Most companies seek to hedge individual exposures, whether it is the currency to be used in an overseas acquisition or the last 20% of next year’s fourth quarter sales that the company may be uncertain about achieving.

“The less certain you are of something occurring that you want to hedge in the future, the more useful options can be,” Mr. Seward said. “An option with a one-sided pay off means you will never be in the position of incurring losses from hedging an event that didn’t occur.”

A banker from Société Générale, which sponsored and hosted the meeting in its New York office, said the bank sees fewer companies using options day to day but instead for specific occasions, such as the upcoming elections in Europe or an M&A transaction.

Companies without a budget to pay the options premium often will employ zero-cost options structures, one of the simplest being a collar in which the corporate sells both put and call options and trades away some downside risk as well as upside gains.

When should companies enter strategies involving options, especially when premiums must be paid? Mr. Seward said the entry point should be when a company believes the likelihood of an event occurring becomes high enough to warrant the price of the hedge, and then it should place a time limit on the derivative instrument. For example, if today it sees a less than 5% chance that China will react to possible US tariffs in the next year, then it’s probably not worth hedging that risk, but a 20% chance may warrant the premium cost.

Cash-flow-at-risk and value-at-risk tools can quantify the likelihood of events happening with hard numbers, Mr. Seward said.

He added that companies with more sophisticated hedging programs, which look at all their risks and consider factors such as volatility and correlation, will use these tools as well. For example, a car manufacturer may forecast that the price of palladium rising above a certain level eliminates profits, regardless of what happens to the various currencies in which they sell cars. After identifying the risk that puts the company in a worst case scenario and using options to hedge it, the company may then find the next worst case scenario and hedge it, and so on, until it has reached the point where the overall risk is at a level it can accept.

“In that case, what helps the company pull the trigger is the time horizon, which could be the product life cycle or its reporting year, and the expected outcome of all the different risks in that time horizon,” Mr. Seward said.

Mr. Seward said such companies face risks across commodity, FX and/or interest rate asset classes, or within an asset class.

“So what they’re really doing is simulating thousands of currency, commodity and interest rate changes, based on what has happened in the past, with a random element, to see what worst case outcomes are likely, and they use that information to make a hedging decision,” he said.

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