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Risk Management

Finding the FX Hedging Sweet Spot

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October 19, 2018

Case study: adding options to layered forward hedges slices FX volatility

econ and currency240Corporate treasuries, especially in the US, tend to use options in limited situations, but new research by Standard Chartered concludes that mixing options into a layered-forwards hedging strategy significantly reduces foreign-exchange (FX) volatility.

Members of the NeuGroup’s FX Managers’ Peer Group (FXMPG) recently discussed in a member roundtable their companies’ use of options and forwards to hedge FX volatility. Few if any acknowledged using them systematically in their hedging programs.

That follows what FXMPG members said in a pre-meeting survey, where 74% of respondents said their FX programs allow flexibility to use forwards and/or options. However, only 35% marked that they currently use options in those programs, with or without premium payments, and 9% affirmed using options only in zero-cost-collar situations.

Just over half, 52%, said they consider the market view of a currency when choosing an instrument to hedge it, and in the meeting most participants involved in the discussion agreed that that was the case when they chose to use options.

One participant, for example, said his company has only used options for “binary-types of events,” and that now treasury is considering whether they’re appropriate, in the context of Brexit, to hedge the uncertainty of whether it will result in a hard or soft landing. Another recounted using options when the Brazilian real and the Russian ruble were weak, and as they’ve gained strength over the last few years the strategy paid off and was then discontinued. A third noted his company’s use of options to hedge currency risk related to large capital projects.

Anthony Ring, executive director of structuring and client analytics at Standard Chartered, had conducted an earlier session reviewing the portfolio approach to risk management. He shared in a discussion on options versus forwards that his bank had just completed research concluding that systematically integrating options into a layered hedging program significantly reduces FX volatility.

“The primary objective of cash flow hedging is to reduce the volatility of cash flows from one period to another due to FX fluctuations,” Mr. Ring said, adding that his premise for years had been that layering only forwards was the most effective way to do that, but that including options was highly beneficial. “We’ve tested it, looking at the method for a few clients, and it’s convinced me that putting options into the program has value.”

A summary and overview report provided by Standard Chartered notes that the most common way to reduce cash flow volatility is to layer into forward hedges. For example, the report says, in a one-year hedging program four forward hedges can be entered into, with tenors of three, six, nine and 12 months. As a result, the next quarter is 100% hedged, the 2nd quarter 75% hedged, and so on.

“In this way, the overall hedge rate achieved for each quarterly exposure is the average of the FX rates from the [four] forwards executed in the prior 12 months,” the report says. “This has the effect of smoothing from quarter to quarter the hedge rates achieved, thus reducing volatility and avoiding the highs and lows.”

The report then provides three examples of introducing at-the-money forward options into the strategy, further reducing volatility by approximately 20%.

One example using euros back tests a quarterly layered hedging program to 2003. In it, 100 million euros are hedged each quarter, notionals split between forwards and options with the same tenors and with at-the-money forward strikes, and option premiums are incorporated in the results.

The test reveals that hedging entirely with options or entirely with forwards results in similar volatility, 3.38% for forwards and 3.83% for options. However, there is a sweet spot, which in this case is 40% options and 60% forwards, in which the volatility drops to 2.73%; that’s 29% less volatility than forwards only, and 19% less than options only.

To explain why options reduce FX volatility, the report looks at the historical hedging rate achieved each quarter, under each layering hedging strategy. It notes that the “only forwards” line is smoother than using no hedging strategy, removing peaks and troughs.

Using only options, instead, enables participation with the unhedged position, following the unhedged position higher, while in a downtrend the options-only mirrors the forwards-only strategy, but is lower by the amount of the options premium.

The strategies using only options or only forwards are smoother than avoiding hedging altogether, although they, too, have their own peaks and troughs. However, those peaks and troughs happen at different times, and so blending options and forwards provides for the smoothest of all the strategies. Back-testing the same hedging strategy for pound sterling showed a similar reduction in volatility, although in this case the sweet spot in terms of the mix of options and forwards was evenly split them.

Responding in the meeting to a member’s question about whether it is options’ asymmetrical payoff that reduces volatility, Mr. Ring said that layering forwards provides an average of all the strikes, so 12 layers results in an average of 12 strikes. Bringing options into the mix provides for some variation.

“You may be averaging 75% of those 12 forward strikes, but options introduce a bit of a spot component,” Mr. Ring said. “It brings an extra averaging component into the exposure.”

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