FX Risk Reversal Extra - Corporates hedging strategy

FX Risk reversal extra is a mixed version of Risk Reversal and Forward Extra FX hedging strategies. Risk reversal extra, or as it’s also known as Cylinder extra, is an option-based hedging strategy. This strategy suits corporation that want to produce themselves with tailor-made hedging instruments that fit their unique needs, such as protecting budget rates, reducing loss probability, and many other reasons.

Risk reversal extra explained - corporate fx hedging strategies.

What is risk reversal extra? hedging strategies using options

A risk reversal extra hedging strategy consists of buying a vanilla option and selling an exotic barrier option at different strikes. The vanilla option buying aim is for protection, and the exotic option selling aim is to finance the bought option, partially or all (zero cost strategy).

Risk reversal extra components, currency hedging strategies for companies

• If exposure direction is to the appreciation of the major currency against the minor, the strategy consists of buying a vanilla call and selling knockin put at a lower strike. The put barrier direction is down & in.

• If exposure direction is to the depreciation of the major currency against the minor, the strategy consists of buying vanilla put and selling knockin call at a higher strike. The call barrier direction is up & in.

Risk reversal extra - What's the “Extra” stand for?

To explain this, we will first define the Knockout / Knockin trigger difference:

• Knockin trigger, if caught - makes the option possible to exercise. 

• Knockout trigger, if caught - makes the option unexercisable.

This strategy involves selling an option, which may result in a loss from the hedging tool in a particular scenario.. However, since this strategy’s sold option is with a Knockin trigger, its initial state is inactive and unrealizable. Selling such an option is, by definition, less risky than selling a Vanilla option with the same strike and time to expiration.

The trigger may exist, but that usually happens in a scenario of relatively sharp exchange rate fluctuations. However, as long as such a scenario does not exist, the hedging company enjoys an extra space where the exchange rate can trade without the hedging strategy incurring a loss.

FX Risk Reversal Extra payoff diagram:

Ex 1: Hedge against EUR appreciation relative to the USD, Risk reversal extra pricing

Explanation:

• Hedge against EUR appreciation above 1.0934. The call option buyer has the right to buy EUR and sell USD at 1.0934.

• Indifference range: between rates 1.0934 to 1.0651 and +1 Pips (1.0652). As long as the market rate didn’t trade during the option life at the trigger rate 1.0651 or below, the hedging instrument will not cause a loss. That is the extra space that the hedging company may enjoy and the reason what this strategy name is Risk reversal extra. 

• If the market rate was traded, during the option life, at 1.0651 or below this rate, the trigger will become active and create an obligation to buy Euro and Sell USD at the rate of 1.0858 (sell put strike).

Ex 2: Hedge against EUR depreciation relative to the USD

Explanation:

• Hedge against EUR depreciation below 1.0845. The put option buyer has the right to sell EUR and buy USD at 1.0845.

• Indifference range between rates 1.0845 to 1.1095 -1 pips (1.1094). As long as the market rate is not traded during the option life at a rate of 1.1095 or above, the hedging instrument will not cause a loss.

• If the market rate was traded, during the option life, at 1.1095 or above this rate, the trigger will become active and create an obligation to sell Euro and buy USD at the rate of 1.0921 (sell call strike).

Barrier type: European or American Options Barrier, what is the difference?

The same strategy can be implemented by using a European barrier type instead of an American barrier, as described in this example. The difference will be the timing in which the trigger can be considered to be active. In the American barrier type, the trigger can become active during all the options life. In contrast, in the European barrier type, the trigger can become active only at the expiry date and at a specific time on that date.  

Premium pricing adjustments:

It is possible to control the premium amount by changing the Call strike and/or the Put strike.

• The closer the purchased option strike is to the forward rate - the higher the strategy premium will be. That is because the protected rate is closer to the market rate, which means better protection and therefore costs more money.

• The closer the sold option strike to the forward rate - the cheaper the net hedging strategy premium will be. The closer the strike rate is to the market rate, the higher the risk of “losing”. Therefore, in return for taking the risk, the option seller will receive a higher premium, lowering the trade date’s net strategy cost.

The derivative pricing calculator reflects the real-time premium price in the OTC market and includes an option payoff calculator and option payoff graph.

End of strategy “life” payoff

For there to be a payout, one of the transaction parties must decide to exercise one of the options that make up the strategy.

Exercising an option

The option purchaser has the right to exercise it at the expiry date and also at a specific hour on that date. The option purchaser will do so only if the exercise of the option is profitable for him. That is, if the execution of a conversion transaction at the option strike is at a better rate compared to the spot rate that can be executed under current market conditions - then the option buyer will exercise it. How to exercise an option? Well, that depends on the market or the platform. In the OTC market, it is also possible to do by a simple phone call, where the exercising party informs the other counterparty on his decision to exercise. The hedging company should keep in mind that if it has sold an option, then the buyer of the option is the bank (or broker), and the exercise right of that option is his.

There are two delivery types:

Once one of the options was exercised, the payout of an option depends on its delivery type, which must be defined at the time of option creation.

• Deliverable options: If an option is exercised at the expiry date, then its delivery will take place two trading days after the expiry date. This means that if the option is exercised, then a conversion transaction occurs between the two transaction parties, at the exercised option strike rate, two trading days after the expiry date. Delivery date = Expiry date + 2 trading days.

• Non Deliverable options: for NDO options, the Expiry date = Delivery Date. At the expiry date, the losing side will pay the transaction payout to the counterparty. In that case, the fixing rate source (Rate at expiry) that will be used to calculate the payout will be specified and documented at the transaction creation. Like in non-deliverable forward, the possible source that publishes fixing rates can be a central bank (Ex. ECB) or Bloomberg (BFIX) or Reuters. If the fixing rate source isn’t a central bank, it’s also essential to specify the exact hour on which the fixing rate is published. 

See the tutorial video: Hedging FX Exposure with Risk Reversal (cylinder) Extra Strategy