FX Risk Reversal strategy, or as it is also known as a cylinder hedging strategy, is probably one of the two most popular options-based hedging strategies. What is risk reversal? What it’s components? How does the payoff diagram look like? How does exercising an option work? What are the delivery types? All and more you will find in this article. 

A cylinder hedging strategy has a chance/risk structure that tends to be balanced. That is, the potential for compensation (protection) is similar to the potential for loss, and theoretically, both are unlimited. In this sense, the cylinder strategy is similar to the forward transaction, but with the addition of a certain indifference range around the forward rate. It is possible to create a balanced cylinder transaction that does not involve a premium payment (zero cost cylinder), but for a premium payment - it is possible to create a transaction with a higher chance than risk in payout terms.

FX Risk Reversal Options Strategy Explained

What is risk reversal? - risk reversal explained

There are two ways to create a cylinder hedging strategy, depending on the exposure direction. The cylinder point of balance reference rate is the forward rate.

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 rate than the forward rate.

• Selling a Put option at a lower rate than the forward rate.

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 rate than the forward rate

• Selling a Call option at a higher rate than the forward rate

Risk reversal components and option payoff diagram:

Cylinder hedge transaction components, for protection against the strengthening of the major currency relative to the minor currency.

FX Risk Reversal pricing and option payoff diagram: 

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. This 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. This is because 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 - which will lower the net strategy cost at trade date.

The derivative pricing calculator reflects the real-time premium price in the OTC market, and also 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 at 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, 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.

Option exercised

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.

There are two delivery types:

• 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 is also important to specify the exact hour of the fixing rate.

Non Deliverable options payoff (payout) formulas

In all the examples below, “Rate at expiry” is the rate that was published by the agreed-upon fixing source.

Non Deliverable options Call potion payoff (payout)

The payout from the option buyer point of view in minor currency terms = 

Max{ 0, (Rate at expiry - Call strike)  x Notional amount in major Ccy terms) }

Example:

Buy EUR/USD call at strike 1.11, notional amount 1,000,000 EUR

The Rate at expiry is 1.1250

Payout = ( 1.125 - 1.11 ) X  1,000,000 EUR = 15,000 USD

If the rate at expiry is 1.10 then the payout is zero, because the payout formula, from the option buyer point of view, can’t be a negative number. 

(1.10 - 1.11) *  1,000,000 EUR = - 10,000 USD

Max { 0, -10,000 USD} = 0

The payout from the option Seller point of view in minor currency terms = 

Max{ 0, (Rate at expiry - Call strike)  x Notional amount in major Ccy terms) } x -1

Non Deliverable options Put potion payout

The payout from the option buyer point of view in minor currency terms = 

Max { 0 , (Put strike - Rate at expiry)  x Notional amount in major Ccy terms) }

Example:

Buy EUR/USD put at strike 1.11, notional amount 1,000,000 EUR

The Rate at expiry is 1.094

Payout = ( 1.11 - 1.094 ) X  1,000,000 EUR = 16,000 USD

If the rate at expiry is 1.121 then the payout is zero, because the payout formula, from the option buyer point of view, can’t be a negative number. 

(1.11 - 1.121) *  1,000,000 EUR = - 11,000 USD

Max  { 0 , -11,000 USD} = 0

The payout from the option Seller point of view in minor currency terms = 

Max{ 0, (Put strike - Rate at expiry)  x Notional amount in major Ccy terms) } x -1