Futures Strategies Currency Management: an Introduction

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Derivatives & Currency Management

Option Strategies Swap, Forwards & Futures Strategies Currency Management: An Introduction

Derivatives & Currency Management

Swaps, Forwards & Futures Strategies

Hedging Bond Portfolio & FI Futures Example Same hedge different hog • Portfolio manager holds EUR50mm in German bunds (principal value)

• Expects a rise in interest rates, wants to fully hedge the portfolio (BPVT = 0) • Portfolio modified duration = 9.50 & MV portfolio EUR49,531,000

NF = (Target Duration – Portfolio Duration)/CTD Bond Duration x (MVP/MVCTD) x CF

See eq. 1 NF = (MDURT – MDURP )/MDURCTD x (MVP/MVCTD) x CF in swaps

NF = (0 – 9.50)/8.623 x {49,531,000/[(98.14/100) x 100,000)]} x 0.619489

NF = -1.101705 x 504.69737 x 0.619489

NF = - 344.45

SAME Conclusion Different Conclusion CTD Bund • To fully hedge the EUR50mm • If interest rate were to • MDUR = 8.623 CTD bund portfolio from rise in fall, the manager could • CTD Bond Price = 98.14 interest rates - sell 344 Euro- extend duration & • CF = 0.619489 bond futures contracts buy FI futures instead

R19 LDI Sec 4.3 Derivatives Overlay BBox 5 BBox 5

Decreasing Portfolio Duration with Futures Duration Modifying Example • Portfolio manager holds EUR50mm in German bunds (principal value) • Expects a rise in interest rates, wants to decrease duration from 9.50 to 8.50, flat YC

• MV portfolio EUR49,531,000 & BPVP is EUR47,054.50

CTD Bund - given Portfolio Target Basis Point • BPVCTD = 84.63 BPVT = MDURT x 0.0001 x MVP • CTD Bond Price = 98.14 EUR 42,101.35 = 8.50 x 0.0001 x 49,531,000 • CF = 0.619489 Eq 9 • MDURCTD = 8.623 NF = (BPVT – BPVP )/BPVCTD x CF

NF = (42,101.35 – 47,054.50)/84.63 x 0.619489

NF = - 58.5271 x 0.619489

NF = - 36.26 sell 36 Euro-Bund futures contracts

Recall How to Calculate BPVCTD Conclusion • To reduce portfolio duration BPVCTD = MDURCTD x 0.0001 x MVCTD from 9.5 to the target duration

MVCTD = (CTD Price/100) x Futures contract size of 8.5 - sell 36 (round down) Euro-Bund futures contracts EUR 84.63 = 8.623 x 0.0001 x (98.14/100 x 100,000) BBox 6 2/16/21 LevelUp, LLC© 2021 All rights reserved 6

Equity Index Return for Floating RR Swap Six Month Equity Swap • Institutional investor with $100mm equity indexed portfolio to the S&P 500 index • Expects market to fall over next 6mos wants to reduce exposure by 30%, NP = $30mm • Pay index return & receive floating reference rate (RR) 2.25% minus 25 bps or 2.0% net Scenario #1: Stock Market Increased 5%

Equity Portfolio 5% x $30mm = $1.5mm Swap Dealer • Pays equity index return • Receives equity index return 2% x $30mm x 180/360 = $300,000 • Receive floating reference • Pays floating RR 2.0% net rate 2.25% minus 25 bps Net payment = $1,200,000

Portfolio P&L • Portfolio gains $5.0mm = $100mm x 5% • Net swap payment to dealer ($1.2mm) • Net portfolio return +$3.8mm or 3.8%

Scenario #2: Stock Market Decreased 5% Swap Dealer Equity Portfolio 5% x $30mm = $1.5mm • Receives negative equity index return • Pays negative 2% x $30mm x 180/360 = $300,000 • Receive floating RR 2.0% = $300,000 • Pays floating • Net return = -$5.0 + $1.8 = - $3.2mm Net received = $1,800,000 RR 2.0% BBox 9 2/16/21 LevelUp, LLC©2021 All rights reserved 7

Managing Equity Risk: Futures Basis Risk Equity Index Futures 3 Calcs Required

• Match U/L with • Equity futures beta βf , portfolio βS 1. # contracts closely related • Index futures do not include dividends 2. Portfolio return index futures • Target/desired beta βT 3. Effective beta • Low cost • F = futures price × multiplier (given) BBox 10 Q2

Increase Equity Risk – Bullish Decrease Equity Risk – Bearish • Buy/long equity forwards/futures • Sell/short equity forwards/futures # of Contracts Eq. 10 æöb - b æöS See eq. 1 N = T S in swaps f ç÷ç÷ èøb f èøF Bullish Outlook Bearish Outlook • Wish to increase beta from 0.75 to 1.10 • Wish to decrease beta from 1.20 to 0.5 • $55mm portfolio • $65mm portfolio • Futures price = $190,000 w/ beta = 0.97 • Futures price = $185,000 w/ beta = 0.98

• Nf = [(1.10 – 0.75)/0.97] x ($55mm/$190,000) • Nf = [(0.5 – 1.20)/0.98] x ($65mm/$185,000)

• Nf = (0.36) x (289.47) Adds risk! • Nf = (−0.71) x (351.35) Reduces risk!

• Nf = 104.45 round down, buy 104 Nf • Nf = −250.96 round up sell 251 Nf

Managing Equity Risk: Futures Bullish Outlook - Portfolio Return & Effective Beta • At contract maturity, the equity market has decreased 3%, equity portfolio fell 1.5% & futures fell from $190,000 to $185,000 • Portfolio value = long equity portfolio + long futures position Critical Idea! • PV = [$55,000,000 × (1− 0.015)] + [104 × (185,000 − 190,000)] • PV = $54,175,000 – $520,000 = $53,655,000

• Portfolio return = PV1/PV0− 1 = ($53,655,000/$55,000,000)−1 = − 2.45% • Effective beta = portfolio return/market return = − 2.45%/− 3.0% = 0.82

Bearish Outlook - Portfolio Return & Effective Beta • At contract maturity the equity market has decreased 3%, equity portfolio fell 1.5% and futures fell from $185,000 to $180,000 • Portfolio value = long equity portfolio + short futures position • PV= [$65,000,000 × (1− 0.015)] + [− 251 × (180,000 − 185,000)] • PV = $64,025,000 + $1,255,000 = $65,280,000

• Portfolio return = PV1/PV0 − 1 = ($65,280,000/$65,000,000)−1 = 0.43% Negative • Effective beta = portfolio return/market return = 0.43%/−3.0% = −0.14 beta?

Eq. 10 BBox 10 Q2

Total Return Swap: Concentrated Positions Concentrated Stock Position Swap dealer pays Equity Swap Dealer • 100,000 shares Tundra reference rate 0.34%/yr. • Receives return on Tundra • Expects stock to fall or 0.17% for 6 mo. • Pays floating RR 0.34%/yr. • Share price $14.00 Payments are NETTED • Portfolio $1.4mm Pay total return on • Stock is not exchanged Tundra $21,620 No exchange • Maintains voting rights of NP

Total Return Swap – Share Price Rises 1% • Over next 6mos, Tundra pays $0.10 dividend/shr & price rises 1% to $14.14 • Total return = (P1 – P0 + Div)/P0 = (14.14 – 14.00 + 0.10)/14.00 = 1.71% for 6mo • Tundra’s return 1.71% > 6mo ref rate 0.17% = pay net 1.5443% x $1.4mm NP = net payment $21,560 paid to the swap dealer since the share price of Tundra rose by 1%

Total Return Swap – Share Price Falls 1% • Over next 6mos, Tundra pays $0.10 dividend/shr & price falls 1% to $13.86 • Total return = (P1 – P0 + Div)/P0 = (13.86 – 14.00 + 0.10)/14.00 = -0.2857% for 6mo • Tundra’s 6mo return -0.2857% - 6mo ref rate 0.17% = -0.4557% x $1.4mm = net payment $6,440 paid to the Tundra owner, swap dealer pays negative return + RR R31 Con Single Asset Sec 4.3.1.1 White Text pg 325-326 EOC 8 2/16/21 LevelUp, LLC©2021 All rights reserved 10

Variance Swap Valuation & Settlement Example 6 Months Later • Olivia Santos sells volatility on the S&P 500 • S&P500 realized volatility • $50,000 vega notional, 1-yr. variance swap currently 16% (annualized) • S&P 500 strike 20% (annual volatility) • Fair strike for the new 6mo variance swap is 19% implied • T = 12 months & t = 6 months • 6 mo. interest = 2.5% (compute PV factor)

PV Factor = 1/[1+ (i x t/T)] 0.987654 = 1/[1+ (2.5% x 6/12)]

Variance Notional = Vega notional /(2 x strike) $1,250 = $50,000/(2 x 20%) Eq 14 Vega notional represents the average profit or loss of the variance swap for a 1% change in volatility from the 20% strike

2 2 2 VarSwap = Var Notional x PVfactor x {t/T x Realized Vol + (T-t)/T x Implied Vol – Strike } VarSwap = $1,250 x 0.987654 x {6/12 x 162 + (12-6)/12 x 192 – 202} = – $112,962.9263 Negative MtM swap value is a positive payoff to the short side…Olivia did GOOD! Olivia sold volatility short when realized volatility 16% was less than the strike 20%

Calculate the settlement amount at expiration if the 1-yr. swap realized volatility is 18%

Settlement = Var Notional x (Realized Vol2 – Variance Strike2)

-$95,000 = $1,250 x (182 – 202)…negative value paid by swap buyer to swap seller Olivia

Using Derivatives to Infer Mkt Expectations Inferring What the Market is Thinking Market participants (MPs) can look to the derivatives markets to infer expectations for interest rates (Fed Funds Futures), inflation (CPI Swaps) & implied volatility (VIX futures). Inferences relate to “current expectations” NOT what will happen, things can & do change Federal Funds Rate Example • Infer probabilities of various • PMgr of short-term floating rate debt wants to understand interest rate level outcomes current market expectations for future Fed rate actions based on FOMC decisions • FF futures contract price = 97.90 1.875% current midpoint • “Pricing in” future monetary • FF current target range set between = 1.75% - 2.00% policy changes • Participant views can E (FFE rate) = 100- Fed funds futures contract price diverge from central bank guidance Exp(Fed Funds Effective rate) 2.10% = 100 – 97.90 • Inferences don’t predict MP’s will expect to see 2.10% FFE rate for the next month well longer term

Probability of Change in Fed Funds Rate – declared move of 25 bps to 2.25% Eff. fed funds rate implied by futures- Current fed funds rate 2.10% - 1.875% P(rate change) = = 90% Fed funds rate assuming rate change- Current fed funds rate 2.125% - 1.875%

Currency Management

Currency Management: An Introduction

FX Quote Conventions The market quoted exchange rate states the amount of the base (B) currency in terms of the price currency (P) in the Price/Base quote. For example, the USD/EUR (“euro- dollar”) 1.36 means that 1 Euro (base) costs 1.36 USD the price currency

Currency Pair Quotes & Hierarchy 1. Currency pairs with EUR will use the EUR as the base GBP/EUR “Its all 2. Currency pairs with GBP will use the GBP as the base – CHF/GBP about 3. Currency pairs with AUD or NZD other than EUR or GBP will use that the AUD or NZD as the base BASE” 4. All other currency pairs using USD will use the USD as the base

P/B = Base – Price USD/Euro = Euro - dollar

Currency Pair Exception • Japanese Yen – JPY • JPY is always the price currency (JPY/B) • Why?...it requires too many yen to buy other currencies thus JPY is always the price currency

Exhibit 2

Currency & Domestic Portfolio Return RDC (domestic asset return) RFC (foreign asset return) RFX (% change in FX vs. domestic)

Domestic Currency Return - RDC Multi-Currency Portfolio Return • Weighted sum of all individual domestic RDC = (1+RFC)(1+RFX) – 1 Eq 1 currency returns RDC Eq 2

Foreign % change in asset return foreign currency Appreciation. vs. Depreciation • The % change in foreign currency in • The domestic currency return RDC is the terms of domestic RFX ≠ %Δ spot P/B foreign asset return RFC measured in local currency terms multiplied by the • If USD/EUR spot = 1.3510 & EUR/USD percentage gain/loss in the foreign RFX rate is 0.7402, then a 5% depreciation in currency relative to domestic currency the USD/EUR spot = 1.3510 × 0.95 = 1.2835 Single Asset Return - Example • If spot appreciates 5% = 0.7402 x 1.05 = Euro domiciled investor buys a USD 0.7772 inverted is 1.2867 ≠ 1.2835 stock. The stock appreciates 8% & the USD appreciates vs. the EUR by 4%, the • 5% change in the USD/EUR is not the EU investor’s domestic currency return: same a 5% move in the EUR/USD

RDC = (1.08)(1.04) – 1 = 12.32%

Currency & Portfolio Return - Example Eurozone Eurozone Canada Canada Blue Box 1 Today – P0 Expected – P1 Today – P0 Expected – P1 ρ(RFC, RFX)

Index Prices - RFC 100.69 101.50 101.00 99.80

CAD/EUR spot - RFX 1.2925 1.3100 +0.5 Expected Return Example

Solve for domestic currency RDC for Eurozone investor holding CAD index

RFC = P1/P0 – 1 = 99.8/101.0 – 1 = − 1.19% depreciating foreign asset (CAD index) ** To solve for the change in the currency first convert the CAD/EUR so the EUR is

the price currency P0 = 1/1.2925 = 0.7737 & P1 = 1/1.3100 = 0.7634 & CAD the base

RFX = P1/P0 – 1 = (0.7634/0.7737) − 1 = − 1.34% depreciating foreign currency - CAD

RDC = (1+RFC)(1+RFX) – 1 Eq 1

RDC = (1 − 1.19%)(1 − 1.34%) − 1 = −2.51%

Domestic currency return RDC for Canadian investor holding eurozone index?

RFC = P1/P0 – 1 = 101.5/100.69 − 1 = + 0.80 appreciating asset – eurozone index

RFX = 1.31/1.2925 − 1 = + 1.35% appreciating currency – euro vs. CAD

Currency & Portfolio Variance

Variance of Domestic Currency Portfolio (foreign asset risk + currency risk)

2 2 2 σ (RDC) = σ (RFC)+σ (RFX)+2σ(RFC)σ(RFX)ρ(RFC, RFX) 2 • σ (RFC) – variance of foreign asset return (Novartis) Correlation b/w foreign asset return RFC 2 • σ (RFX) – variance of future exchange rate movement (CHF) & currency spot rate RFX • Risk is usually defined in standard deviation terms σ, not variance • There are no weights ω in the equation as currency weight has an implied weight 1.0 • If the asset were shorted, then asset weight would be negative 1.0

2 σ (RFC) Blue Box 7 (pg. 397) Portfolio st dev w/ short positions Having long +1 weight & short positions -1 weight between two positively correlated +ρ currencies

can reduce portfolio risk σ(RDC) Look for the negative 2 2 σ (RFX) BBox 7 Mai Nguyen Single Asset & Portfolio Return

Currency & Portfolio Variance- Example Eurozone Eurozone Canada Canada

Today – P0 Expected – P1 Today – P0 Expected – P1 ρ(RFC, RFX)

Index Prices - RFC 100.69 101.50 101.00 99.80

CAD/EUR spot - RFX 1.2925 1.3100 +0.5

Variance Example From a Canadian investor perspective:

σ(RFC) = 3% expected risk for the foreign asset

σ(RFX) = 2% expected risk of the exchange rate movement

ρ(RFC, RFX) = + 0.5 correlation b/w foreign asset & exchange rate movement

What is the expected risk of the domestic currency return σRDC for the CAD investor? 2 2 2 σ (RDC) = σ (RFC)+σ (RFX)+2σ(RFC)σ(RFX)ρ(RFC, RFX) σ2(R ) = (0.03)2 + (0.02)2 + (2)(0.03)(0.02)(0.5) Be careful using DC variance & 2 σ (RDC) = 0.0019 standard deviation In standard deviation terms:

Manage Currency Risk or Not? Two Opposing Views Hedging Costs • In the long-run, there is a belief that currency Hedging is not free movements net to zero, exchange rates revert to 1. Trading Costs fundamental values, believe in EMH, zero-sum • Dealer bid-offer spreads • In the short-run it is possible to “harvest alpha” • Up-front premiums on long due to (1) pricing inefficiencies (2) trade & capital currency options EOC 3 flows & (3) diversity of market opinion (retail) • Cash liquidity required for rolling IPS Mandate to hedge more currency risk if… forward contracts, increases • Short-term investment horizon cash account volatility • BOD doesn’t see benefit of active currency mgt. • Infrastructure & back-office costs • Show greater risk aversion (no ex post regret) 2. Missed opportunity costs • Lower near term liquidity needs BBox 8 Q1 3. Forward roll costs - contango • Hedging program is cheaply available EOC 24 • 100% hedge ratio removes any favorable currency movement & • Currency exposure adds to diversification may lead to ex post regret • Hedging is more likely with fixed income portfolios, bonds & currency are both impacted Use of a 50% hedge ratio avoids by interest rates thus currency exposure with both ex ante & ex post regret, EOC 4 bonds adds little to diversification, s/b hedged regret minimization Kailua Kona Advisors 2/16/21 LevelUp, LLC©2021 All rights reserved 19

The Currency Risk Spectrum

Extreme risk Seek aversion IPS Mandated currency risk Fully/Passively Discretionary Active Speculative Trade Hedge Hedging Management • Full blown active • Rules based • Limited discretion • Goal - add alpha currency trading • No mgt discretion • Goal: protect • Mgr. expresses • Net short volatility • Minimize tracking portfolio from speculative view • Stable mkt, keep prem error with BM currency risk with “limited • Most expire OTM directional bets” • Match currency • Start with neutral EOC 7 exposure with BM benchmark for • Risk mgt. limits See IPS “Kailua Kona” • BM (local currency currency exposure exposure EOC 24 Investment Policy Stmt +/- x% tolerance index) usually has Currency Overlay range, net long no currency • Currency is viewed as an “alternative • Manager has exposure (bonds) asset class” & actively managed • Rebalancing due limited ability to express • Outsourced to external FX mgr. to hedge ratio • Separates currency alpha & beta drift – costly “directional views & opinions” • Free to gain exposure to any value- • éRisk aversion • Performance added currency – requires monitoring éRebalancing compared w/ BM BBox 2 Q2 EOC 5 & 15 BBox 2 Q1 EOC 12 EOC 14 2/16/21 LevelUp, LLC©2021 All rights reserved 20

4 Reasons to Trade FX - “Tactical” Views Long-run real exchange rates converge to fair value, while short & medium term factors shape the convergence to equilibrium – governed by purchasing power parity

1. Trade on Economic Fundamentals 2. Trade on Technical Analysis

The base currency in the (P/B) real TA ignores economic analysis exchange rate will é appreciate… 1. Believe historical price data can be • Rise in the long-run equilibrium real used to predict future price moves exchange rate Exhibit 5 2. Historical patterns & trends repeat • Rise in real or nominal interest rates, 3. Prices reflect market psychology, attracting foreign capital investment inflows anticipate where FX “will trade” NOT • If the current real exchange rate is below where it “should trade” its long-run equilibrium value & reverting • Less useful in trendless market • Tighter monetary policy, leads to é EOC 13 • Used in over bought/sold markets real rates with no inflationary pressures • Identifies support & resistance levels BBox 3 Annie McYelland Q2 & Q3 with clustering of bids around 200 & 50 • Rise in expected foreign inflation, day moving averages, turning points causes foreign currency to depreciate BBox 3 Annie McYelland Q5 • Rise in the foreign risk premium, foreign 3. Forwards & Carry Trades è assets become more risky & less attractive thus currency depreciates 4.Currency Volatility w/ Options è EOC 6* LevelUp, LLC©2021 All rights reserved 2/16/21 21

Carry Trade & Forward Rate Bias Carry Trade Uncovered IRP

• Borrow in low-yield/high priced currencies % Δ spotH/L ≅ ihigh yield – i low yield • Invest in high yield/low priced currencies • The yield spread advantage b/w the • Carry trade is a levered position high & low yield will be matched by • Exploits uncovered interest rate parity depreciation of the higher yielding currency

**Trading Forward Rate Bias (FP/B – SP/B) • The low yield currency is the base,

• Buy currencies at forward discount thus making % Δ spotH/L appreciate when market is in backwardation F < E(S) • Yields & prices move inversely • Sell currencies at a forward premium • Problem: long periods small gains, when market in Contango F > E(S) brief periods of large losses (- skew)

Exhibit 6 Buy/Invest Sell/Borrow/Fund Carry Trade Buy high-yielding currency Sell low-yielding funding currency = Buying low priced currency = Selling high priced currency Trading the Buy currency at forward discount: Sell currency at forward premium: forward rate bias Spot > Forward = Backwardation Spot < Forward = Contango Currencies Emerging market, higher risk Funding currencies: USD, CHF, JPY, investment currencies GBP (safe havens) borrowing occurs YC Strategies – BBox 5 EOC 19 BBox 3 Q1 2/16/21 LevelUp, LLC©2021 All rights reserved 22

Forward Contract Roll Yield

Backwardation – Short Hedge Contango – Short Hedge “Don’t be short with me, I’ll backhand ya!” “I wanna be short dancing the Con-tango”

• Sell forward at discount/cheap price • Sell futures at forward premium Short @ • Buy/cover at higher spot price – dope! • Sell high, buy lower price spot Forward premium • Negative roll yield, negative carry • Positive roll yield -S ç Buy/cover Roll +F Roll ç @ higher Short @ BBox 4 Q2 BBox 4 Q1 Buy/cover @ spot price forward Short ZAR in +F Short GBP in cheaper spot -S discount backwardation Contango

Backwardation – Long Hedge Contango – Long Hedge • Buy forward at discount/cheap price “You’re cussing if you’re long in Contango” • Sell spot at premium price – brilliant! • If you buy at forward premium and sell at • Positive roll yield/positive carry trade lower price spot, F rolls down to S earns Bought @ • Trading with the forward bias • Negative roll yield/carry trade Forward • Trade against fwd bias premium Sold @ +S higher çRoll Roll - F spot price Bought @ ç forward BBox 4 Q1 Sold @lower White text ex. pg. -F discount Initially long GBP spot price + S 380 Long GBP in Contango

Hedging Using Forwards - Example Ivory Capital, located in Hong Kong, uses the HKD as its reporting currency. The firm invests in U.K. equities & South African gold mine stocks. The investment committee is wondering whether it should hedge its long exposure to the GBP & ZAR

6-mo forecasted P/B Quote Spot 6-month forward spot rate HKD/GBP 12.4610 12.6550 1.6% premium 12.3000 discount HKD/ZAR 0.9510 0.9275 2.5% discount 0.9300 discount

Contango – Short Hedge HKD/GBP Backwardation – Short Hedge HKD/ZAR “I wanna be short dancing the Con-tango” “Don’t be short with me, I’ll backhand ya!”

• Sell futures at forward premium Sell @ • If you sell at a forward discount then • Sell high F, buy lower price S forward buy/cover short at higher price premium Buy/cover • Positive roll yield +12.655 • Negative roll yield @ higher = (F-S)/S = +1.56% =(F-S)/S = - 2.47% +0.9510 spot price Sell @ forward Fcst expects depr. Buy/cover Don’t short in discount -12.4610 @ cheaper -0.9275 Thus hedge spot backwardation But based on 6-mo fcst, don’t short hedge - backwardation But based on 6-mo fcst, don’t 100% hedge

Motivation: Profit from FX Volatility

Volatility or “VEGA” Trades 3 Volatility Strategies è • Delta hedges away FX price risk 1.Long Straddle = LC ATM 50D + LP ATM • Trade currencies to express “view on 50D, debit strategy (investment), bet big future exchange rate movements” not currency moves in either direction (∨ the direction of the currency movement shape), expensive strategy, D neutral ²Overlay mgrs are net-short volatility: 2.Short Straddle = SC ATM + SP ATM, why?...most options expire OTM thus credit strategy receive 2 premiums, bet on keep premiums & generate income flat market – stable spot (∧shape) income ²Hedgers are net-long volatility buying 3.Long Strangle = LC OTM 25D + LP OTM protection from adverse currency moves 25D, cheaper strategy (bowl shape) Put Deltas – negative values Call Deltas – positive values | | | | | | | | 50 25 10 10 25 50 100 delta 100 delta Quoted in Deep ITM delta delta Delta Absolute delta delta delta Deep ITM terms Very ATM OTM OTM OTM OTM ATM Very Expensive Expensive cheap cheaper cheaper cheap Expensive Expensive Premium Premium Cheaper 0 = OTM Cheaper BBox 3 Q4 BBox 6 Q2 & 3 But more downside risk Cheapest BBox 5 Q4 Premium R15 Options Sec. 4.1.3.2 BBox 8 Q2

3 Volatility Trades using Currency Options 1. Profit in High Volatility Mkts 2. Profit in Low Volatility Mkts Motive: FX appreciates or depreciates Motive: FX stays flat, collect 2 premiums Long Straddle = LC ATM + LP ATM Short Straddle = SC ATM + SP ATM Exercise Price LP ATM 50D LC ATM 50D Profit Profit ------

+ + - + - - FX Price FX Price Loss ------Loss Exercise SP ATM 50D SC ATM 50D Price Expensive! Asset better NOT move!!

• Time value (theta) 3. Cheaper Bet on Large Volatility Moves • Short Strangle declines as they • Long Strangle = LC OTM + LP OTM SC OTM + SP OTM move toward expiration LP OTM LC OTM 25, 10 or 0D Less income in Profit 25, 10 or 0D flat markets but • Options have no + + safer strategy opportunity costs - FX Price ------Less expensive! but require cash Loss ------for upfront Exercise Price premium pmts BBox 3 Q4 R15 Options Sec. 4.2 2/16/21 BBox 8 Q4 LevelUp, LLC©2021 All rights reserved 26

Ways to Reduce Hedging Costs - part I It is expensive to remove all currency downside risk. Hedging is insurance against adverse currency movements but portfolio managers can overpay for protection

Basics Protective Puts using OTM (not ATM) Options • Cost reduction but comes with less “Increase deductable to reduce premiums” downside risk protection • Protective puts using ATM 50D options is • Hedging is more active, very expensive, buys convexity discretionary & not “rules based” • Alternatively, use cheaper OTM 25D or deeper • Assume we sell short the base in OTM 10D options that are less costly but come P/B quote to reduce currency risk with more downside risk & less protection

Reduce protective put hedge costs by selling or “writing” options

Short Risk Reversal (Collar) Long Risk Reversal = LP OTM + SC OTM + Long FX = LC OTM + SP OTM + Short FX • “Zero-cost collar” strategy where a • Another “collar” strategy where the long 25D put is expensive but cost long 25D call is expensive but cost BBox 6 Q1 reduction comes from selling 25D reduction comes from selling 25D call = “short 25D risk reversal” w/ put = “long 25D risk reversal” w/ BBox 8 Q3 long base, bearish & uncertain vol short base, bullish & uncertain vol Exhibit 9 EOC 21 Reverses volatility skew! R15 Options Sec. 3.5 2/16/21 LevelUp, LLC©2021 All rights reserved 27

Ways to Reduce Hedging Costs - part III “Winged” creature option strategies (Seagulls & Butterflies – R33) involve 3 or 4 options. The “wings” are options with most distant OTM strikes & the body is the middle ATM strike. In all cases, manager is long the base currency in the P/B quote

Short (wings) Seagull Spread Long (wings) Seagull Spread SP OTM + LP ATM + Long FX + SC OTM LP OTM + Long FX + SC ATM + LC OTM

Bear Put Spread + Covered Call Long Strangle + Covered Call • Spot FX at 1.355 • Spot FX at 1.355 • Protective put w/ long ATM put @1.355 • Long strangle with OTM LP + OTM LC • Short OTM put & call ê hedge cost • Short ATM call ê hedge cost Short OTM Put @ 1.350 - wing Long OTM Put @ 1.350 - wing Long ATM Put @ 1.355 - body Short ATM Call @1.355 - body Short OTM Call @ 1.360 - wing Long OTM Call @ 1.360 - wing • Downside protected 1.355 to 1.350 • Cheap downside risk protection - OTM LP • Limited upside 1.35 to 1.360 SC strike • Unlimited upside if FX appreciates above • Collect two premiums on SP & SC 1.360 long call strike • Safe strategy since long put is ATM • Buying two options LP & LC - more costly BBox 6 Q1 2/16/21 LevelUp, LLC©2021 All rights reserved 28