Managing FX Risk via Advanced Hedging Strategies
According to the most recent Bank of International Settlements (BIS) survey, published in December 2011, and based on statistics as at 30 June 2011, the foreign exchange (FX) market has shown an overall annual increase of 12% in notional amounts traded. In addition, there has been a 26% increase in FX options traded under one year maturity, coupled with a sharp decline of 48% in the number of long-term FX derivatives contract (five years and traded longer). The change could reflect more conservative counterparty risk management and the application of credit value adjustment (CVA).
Overall, from December 2010 to June 2011 FX options volumes increased by 12.5%; interestingly a proportionally larger increase than that for forwards and FX swaps. This could reflect the lower volatility experienced over the period that made the purchase of options cheaper, or an increased appetite for trading non-linear products.
Figure 1: Trends in FX Over-the-counter (OTC) Trading
Figure 2: EUR/USD Spot Rate Chart
Given the market volatility and the euro’s weakness since summer 2011, for corporates with multi-currency exposures the need to hedge foreign-denominated receivables has never more timely or prudent in effectively managing the balance sheet. By suggesting potential advanced hedging strategies, this article aims to demonstrate a cost-effective way for corporate treasurers to mitigate FX risks.
Google as a Business Case
To illustrate the available hedging options, Google will be used as an example of a US corporation with multinational activity, which generates multi-currency underlying assets’ exposure with a significant dollar cost base and subject to significant FX rates fluctuations.
This business case will examine various advanced FX hedging strategies, and their impact had Google deployed them within this time period. It commences with single asset strategies such as average rate options, partial barrier forward, compound options and gated knock out.
Google’s activity generates multi-currency exposure, which would suggest a multi-asset hedging strategy as this has proved efficient and cost-effective. Finally, it examines the multi-asset strategies of cross-asset knock out and a basket option.
An explanation and analysis of each structure compares their respective payoffs and costs.
In financial reports, specifically its SEC 10-K Form of December 2011 , Google disclosed the usage of FX derivatives used to hedge its exposures during 2011:
(Note: The option classes were not disclosed in the report)
Google details its scenario analysis policy by applying 20% shifts up and down, in euro/US dollar, pound/US dollar and US dollar/Canadian dollar respective spot rates. The results, in millions of dollars, are shown in Figure 3, derived from the financial reports of Google in December 2011.
Figure 3: Google: Scenario Analysis Results (December 2011)
As seen from the table, when a 20% shift is applied Google is fully hedged against both scenarios. A 20% US dollar strengthening, which is the main concern and reason for applying the hedging policy, would generate a positive income of almost US$1bn, while a 20% weakening of the currency would have a relatively minor impact on Google’s net income.
Potential Hedging Strategies that Google May Use to Address FX Exposure
This section suggests the different hedging strategies that may be used by Google to address its FX exposures.
Any prudent treasurer aims to mitigate currency risk on an on-going basis. For Google, given its reported exposure to the weakening euro, there is an immediate requirement to hedge euro receivables. The group has the following options for hedging:
The market rates used across the pricing exercise were as follows:
For simplicity we priced six month contracts, for a notional amount of US$100m with a strike price of 1.3200.
Google entering a vanilla option
Google buys a euro put/US dollar call option where the strike price is set at 1.3200. As a buyer of this option, the company would pay a premium of €1.95m.
Google entering into exotic options strategies
In the average rate (Asian) options strategy, the buyer purchases a euro put/US dollar call option, struck at 1.3200 with monthly fixings, which would expire in six months from the trade date – i.e. 3 October for a premium of €950,000. The premium for this option is significantly lower than that for the equivalent vanilla option of €1.95m. The fixing source has to be agreed upon inception (examples: European Central Bank (ECB) fixing published 14:15, Frankfurt, or WMR spot fix).
The payoff of this strategy would be as follows (upon expiry date):
Partial Barrier Forward
This strategy is composed of the following two options: the buyer buys a put euro/call US dollar vanilla option at a strike price of 1.3200 and sells a call euro/put US dollar partial barrier option at a strike price of 1.3200, with a knock in trigger set at 1.3535.
The sold option would only be activated if the market trades at 1.3535 or above between the dates of 3 April and 3 May.
The cost of this strategy is zero, as the premiums of both options offset each other.
The payoff of this strategy would be as follows:
Using this option, the buyer holds a compound option at a strike price of 1.3200. The buyer has the right, in three months, to buy a vanilla option (put euro/call US dollar struck at 1.3200) that would expire in six months from now. Hence, by purchasing the compound option the buyer pays an initial premium of €920,000 upfront, but in case the compound option is exercised an additional premium of €1.5m would have to be paid to the seller.
The payoff for this strategy would be as follows:
Use Case 2: Compound Option
Google is to participate in a tender in euro land. In this particular case, the company wishes to hedge an uncertain FX risk that would persist only if it wins the tender. As in the previous use case, its receivables would be dominated in euros and an underlying exposure would be generated. If it loses the tender, there would be no FX risk. So Google wishes to hedge this potential FX exposure at minimal cost. Instead of buying a vanilla option, the company would be buying a compound option.
Gated Knock Out
Google buys a put euro/call US dollar option with a strike price of 1.3200 and a knock trigger set at 1.3600, for a premium of €1.19m.
Every day the euro/US dollar spot rate is observed, and for as long as 1.3600 level doesn’t trade Google would accumulate a proportion of the notional amount (n/N * US$100m). As an example, if in three months precisely the market trades at 1.3600 the accumulated amount would be US$50m.
Potential scenarios at expiry:
Using this strategy, Google would be buying a fade-in option as follows:
Google is fully hedged as long as the market doesn’t trade at 1.3600. If the market trades below 1.3200 at expiry, then the option would be exercised. However, if at expiry the market trades above 1.3200, the option would lapse and Google would have to sell its euros at the prevailing market rate.
This section considers the usage of two multi-asset strategies: cross asset knock out and basket options.
1. Cross-asset knock out
Google is buying a put euro/call US dollar option, struck at 1.3200 that would knock out only if the pound/US dollar spot rate trades above 1.7000, which compares with a rate of 1.6010 as on April 3rd. The cost of this option is €1.70m. As this is a multi-underlying assets structure, it is necessary to observe the correlation of these two underlying assets; estimated at 0.7 as this option was priced.
If the market trades below 1.3200 at expiry and the pound/US dollar spot rate never traded at 1.7000 or above, the option would be exercised. If the market trades above 1.3200 at expiry the option would lapse, and Google would buy its dollars at the prevailing market rate.
If the pound/US dollar trades at 1.7000 or above, the option would be knocked out and Google would have to apply an additional hedging strategy.
2. Basket options
This article has discussed various hedging strategies: single asset (average rate options, partial barrier forward, compound option and gated knock out) as well as multi-asset strategies (cross-asset knock out and a basket option), in each case analysing the strategy’s respective payoffs and the advantages. The cost of the options varies; in all cases but one (compound option, when exercised) the suggested strategies cost less than an equivalent vanilla option. Each option has a unique profile that could be used in an adequate use case (exposure) according to the hedging policy of the firm.
In hindsight, the most effective strategy would have been entering a partial barrier at a zero cost. The reason being that the sold option-partial barrier call euro option would have lapsed and Google would have been long a vanilla put euro option, struck 1.3200 purchased at a zero cost.
Figure 4 summarises the strategies suggested, as well as a target redemption forward for reference.
Figure 4: Summary of Suggested Strategies
The unprecedented levels of volatility experienced over the past two years, coupled with the high level of uncertainty, have been drivers for adopting a prudent approach to managing FX exposures. When deciding and implementing a hedging programme one must take into account the historical and projected underlying prices fluctuations, examine and select the most suitable hedging strategies, as well as running the selected programme through various potential market scenarios and determine its efficiency. Decision support systems to assist with managing the hedging process are readily available.