By Anne Friberg
Selling options earns premiums and gives a chance for better execution rates than leaving overnight hedge orders.
Next time your FX policy is up for review, consider this: are you allowed to execute your hedges over a period of time (rather than immediately); can you act on a currency view; and are you permitted to sell options? For most companies, the answer is probably yes, yes, and no, and that’s the end of it. For some, selling options is only permitted when combined with buying options, e.g., when putting a collar in place.
But if you think you might have some more policy wriggle room, read on.
While the policy does not allow for speculative trading positions, one company with a big short CAD exposure is permitted to sell short-dated call options. In doing so, it collects around USD 0.5 million per year in premiums, which go toward funding more expensive options strategies needed by a geographically spread out company that does a lot of business in emerging markets.
HOW IT WORKS
Where the policy permits hedges of forecasted transactions to be executed over a certain timeframe, treasury may use its best efforts to execute trades at more favorable rates. This may involve one or more of:
- Monitoring the FX markets to execute trades at a later time;
- Leaving an order to be filled at a more favorable level;
- Leaving stop loss orders to be executed if the currency moves in an unfavorable direction; or
- Selling currency options to generate premium income while waiting for more favorable levels.
The key to the fourth strategy is that the company limits itself to selling very low-risk overnight call options: it sells a low-delta call option on the currency it wants to hedge instead of leaving an overnight order for a hedge it’s planning to put on the next day. Ultimately, the company needs to buy CAD and sell other currencies, so it sells CAD puts and sells calls on the other currencies. The choice of a low delta helps capture the “smile” of the volatility curve—that is, the pricing discrepancy that arises as options move further out of the money.
If the option is exercised, the company gets hedged at a better price and collects the premium. If not (although it’s rare), it doesn’t get hedged and the premium collected does not compensate for the rate going against it. “It’s like picking up pennies in front of a steam roller: every once in a while you get hit,” remarked the company’s FX director.
For instance, if treasury expects a weaker CAD during the next few days based on both fundamental and technical views and also feels that volatility is high, it’d be a better option seller than buyer, and they’d sell the CAD put. As long as the strike trades on the exercise day, the company can roll this to a forward contract with any bank or dealer.
BUT HERE’S THE RUB
The only problem might come on “exercise day” (Day 4 in the example) when the day’s range was outside of the exercise level (the market trades 1.0450-1.0510, but the exercise was at 1.0350). Banks are reluctant to roll the trade forward at 1.0350, as audits will show that the rate never traded on that date. The company would have to settle the option exercise (at 1.0450) for a loss, then put the forward on at 1.0450 plus/minus forward points.
RISK OF A SMALL PREMIUM
The other risk is that the view is wrong. While a company may keep picking up premium, the CAD could trade stronger. If the “scenario spot” in the example was 1.01, the only money the company would pick up would be a small premium—in that case, the company really should have done the hedge at 1.0220. This “overnight call options” strategy is only useful when you feel pretty strongly about the direction of the market over the next week or two.
The options themselves do not get hedge accounting treatment. But hedge accounting is appropriate for the forward trade at market levels if and when it is exercised. This should be transparent and acceptable to auditors.
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