By Anne Friberg
Delta hedging allows treasury to lock in the spot rate, increasing control over the execution.
Many factors affect the premium of an FX option trade. The primary moving parts are the implied volatility and the spot rate. Option users can consider taking one of those out of play by “freezing” the spot reference rate for the trade by way of delta hedging. That involves setting the spot with one bank and then bidding out the option to several banks—with the spot rate as a given.
Stop Spot from Running
Delta hedging is particularly appropriate when executing a large option deal structured in several tranches with different expiry dates. Over the time that it takes to execute a series of hedges, the spot rate will move some, and perhaps significantly, with a potentially large impact on the premium. Delta hedging allows a company to lock in the spot reference rate for all the individual tranches of the deal. This makes for a more efficient competitive-bid situation, since banks’ risk is limited to implied volatility and not spot movements. This, in turn, puts the bidding banks on an even playing field and allows the company to compare bids more easily.
An FX director in one of The NeuGroup’s FX Managers’ Peer Groups (FXMPGs) notes that delta hedging reduces the risk that the bank will take a position against the company, which could also affect pricing. In addition, large deals can take a while to price and execute, and delta hedging allows for a more controlled execution, with no pressure to attempt to time the spot market. Finally, delta hedging permits a company to spread its business around to more banks, helping solve the share-of-wallet dilemma faced by many companies with big bank groups.
triangular logic
In terms of executing the trade, it is important to be very clear with the bank that you are doing a delta exchange, and to send the bidding banks all the option requirements on a spreadsheet to avoid any possible errors or confusion. Also, set a time limit for the banks to get back with their option bids.
Assume a company’s goal is to buy a EUR 100 million put option with a locked-in spot rate. To hedge its position with the company, the bank (the option seller) would need to sell the delta amount of euros to the market. In a delta hedge, the company takes the market’s place by buying the euro delta amount instead (and simultaneously selling it to the market, resulting in two spot trades, or a pass-through).
The delta to sell for an at-the-money forward option (ATMF option) is approximately 0.5—EUR 50 million in this case—but not exactly: due to the present-value effect (the interbank market exchanges delta on a forward basis) and the currency used to pay the premium, which could be USD, there will be a differential. The differential grows bigger if the expiry date is distant, there’s a large currency-pair interest-rate differential or you’re dealing with a very low delta (out-of-the-money) option. The further out of the money, the more the delta hedge amount is affected by the “volatility smile,” the growing divergence from expected prices using the Black-Scholes calculation as options move further out of the money.
not for novices
Treasuries need significant in-house resources to pull off these deals effectively. A senior FX banker with a global institution says it is a way for a corporate client to spread business around to several banks, and, “frankly, we don’t care” from a trading perspective whether the client chooses to delta hedge or not. Bankers say the companies most likely to engage in delta hedging have larger and more sophisticated treasuries, with plenty of options experience.
“Perhaps between 5 and 10 percent of our corporate clients do it,” estimated one FX banker. But it’s not only sophistication; it also takes access to cash, cautioned another FX pro. From a liquidity point of view, the company has to have the cash available to execute both the cash trades and consider the possibility of timing differences in incoming and outgoing flows. These transactions are also operational burdens. To lessen the hassle, companies should do their delta exchanges with only one bank.