FX Risk Reversal options strategy with limited potential loss - an advanced risk reversals

Limited loss risk reversal is a more conservative hedging strategy compared to a regular risk reversal that has theoretically unlimited potential loss. Risk Reversal is also known as a Cylinder strategy.

Risk reversal options guide

Limited loss risk reversal strategy consists of three Vanilla options, compared to two Vanilla options in a regular risk reversal. The additional option purpose, compared to a regular cylinder, is to limit the potential loss that can be caused by the sold option. Since the potential loss in this strategy is limited, the hedger should be willing to pay a premium for it. For comparison, since the potential loss in a regular risk reversal strategy is unlimited, it is common to execute it without paying a premium (Zero cost).

Limed loss Risk Reversal component 

When exposure is to exchange rate decline (↓) (Depreciation of the major currency relative to the minor currency), the cylinder component will be:

• Purchase a Put option at a lower strike than the forward rate.

• Selling a Call option at a higher strike than the purchased put option strike.

• Purchase a Call option at a higher strike than the sold call option strike, to limit the risk evolving from the sold call option.

When exposure is to exchange rate increases (↑) (Appreciation of the major currency relative to the minor currency), the cylinder component will be:

• Purchase a Call option at a higher strike than the forward rate.

• Selling a Put option at a lower strike than the purchased call option strike.

• Purchase a Put option at a lower strike than the sold put option strike, to limit the risk evolving from the sold put strike. 

Limit loss Risk Reversal payoff diagram:

Limed loss risk reversal component when exposure is to exchange rate decline (↓)

Limited loss Risk Reversal option stategy pricing

Ex 1. Protection from the depreciation of the EUR against the USD

Explanation:

• The strategy protects against the depreciation of the euro against the dollar below 1.0835 rates. The put option buyer has the right to sell euros and buy dollars at this rate.

• Indifference range between rate 1.0835 to 1.0923. If the strategy expires when the market rate is within the indifference range, then the strategy will not create a profit or loss.

• Obligation to sell Euro at the rate of 1.0923 in the scenario if the market rate at expiration is higher than this rate. The potential loss is limited until the rate 1.1145 because, at this rate, the call option buyer has the right to buy euros at 1.1145.

Additional points to note:

• Buying vanilla put at 1.0835 would have cost 1.895% (18,948 EUR) (as a stand-alone strategy).

• Instead, this strategy costs 1.0775% (10,775 EUR), but new a potential loss element was added.

Maximum potential loss = (1.0923 - 1.1145)1,000,000 EUR = 22,200 USD. 

Ex 2. Protection from the appreciation of the EUR against the USD

Explanation:

• The strategy protects against the appreciation of the euro against the dollar above the 1.1159 rates. The call option buyer has the right to buy euros and sell dollars at this rate.

• Indifference range between rate 1.1159 to 1.1049. If the strategy expires when the market rate is within the indifference range, then the strategy will not create a profit or loss.

• Obligation to buy Euro at the rate of 1.1049 in the scenario where the market rate at expiration is lower than this rate.  In such a scenario the strategy will create a loss.

  • The potential loss is limited until the rate of 1.0849 because, at this rate, the company bought a put option that gives her the right to sell euros at 1.0849. Therefore the maximum potential loss is limited to = (1.0849 - 1.1049)1,000,000 EUR = - 20,000 USD.

Limited loss risk reversal pricing adjustments:

It is possible to control the premium amount by changing the strikes. Yet the hedger that chooses this strategy should be willing to pay a net premium.

• The closer the purchased option strike is to the forward rate - the higher the strategy premium will be. 

• The closer the sold option strike to the forward rate - the cheaper the net hedging strategy premium will be. This is because the closer the strike rate is to the market rate, the higher the risk of “losing”. In some cases hedgers sell an option in the money, to finance and reduce the net strategy premium.

• The lower the potential loss is, the higher is the net strategy premium.

Watch the tutorial video: FX hedging with limited loss Risk Reversal strategy options srtategy