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Instruments and How to Use in Practice

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Instruments and How to Use in Practice Danske Bank FX School FX Structuring: Morten Helt 19 August 2020 +45 33 64 81 30 [email protected] Important disclosures and certifications are contained on the last page of this report. Agenda Part 1: Currency hedging: Why and how? Part 2: Hedge instruments and how to use in practice Part 3: Accounting and currency hedging 1 Part 2: Hedge instruments and how to use in practice . Introduction to FX options . Options versus FX forwards . Danske Bank’s Hedge Instrument Guide 2 Currency options – what is it? A currency options gives the buyer a right, but not an obligation to exchange a predefined amount at a predefined exchange rate (strike) on a specific day. In order to obtain this right, the buyer pays a premium to the seller of the option. You can regard a bought option as an insurance against unfavourable currency movements. It will provide you with a worst case scenario, just as a regular insurance. The premium is determined by the strike, the forward rate, and the market volatility. 3 The price of options – Implied volatility Source: MacroBond & Bloomberg 4 Example – company with costs in EUR Buy a 3 month EUR/NOK call option: 10.9 Buys the right to buy 100.000 EUR/NOK in 3 months 10.8 at rate 10.70 10.7 Option cost a premium of 0.1250 points 10.6 (12.500 NOK per 100.000 EUR notional) 10.5 10.4 Full protection above 10.70 10.3 10.2 Worst case effective rate = 10.70 + 0.1250 = Effective Exchange Rate Exchange Effective 10.1 10.8250 10 10 10.4 10.6 10.8 No obligations (full profit potential) if spot rate declines. 10.2 10.76 10.04 10.08 10.12 10.16 10.24 10.28 10.32 10.36 10.44 10.48 10.52 10.56 10.64 10.68 10.72 10.84 10.88 10.92 EUR/NOK spot rate at expiry Worst case loss is the premium paid Source: Danske Bank 5 Reducing premium cost, by combining options Premium cost can be reduced or eliminated by combining call/put options Examples (6 month strategies): 10.9 Risk Reversal: 10.8 – Buy a call option to hedge currency 10.7 expenses 10.6 – Sell a put option, that finances the call Effective Effective rate 10.5 option, but caps your gain 10.4 – Fully hedged above 10.8250 10.3 11 – Full participation down to 10.4000 10 10.4 10.2 10.6 10.8 10.56 10.72 10.88 10.04 10.08 10.12 10.16 10.24 10.28 10.32 10.36 10.44 10.48 10.52 10.64 10.68 10.76 10.84 10.92 10.96 – Zero Cost EUR/NOK at expiry Participating Forward: 10.8 – Buy a call option to hedge currency 10.7 expenses 10.6 – Sell a put option in 50% of the call notional, 10.5 that finances the call option, but allows 10.4 Effective Effective Rate unlimited market participation in 10.3 10.2 remaining 50% notional 10.1 – Full hedge above 10.73 10 10.6 10.2 10.4 10.8 10.76 10.92 10.04 10.08 10.12 10.16 10.24 10.28 10.32 10.36 10.44 10.48 10.52 10.56 10.64 10.68 10.72 10.84 10.88 – 50% unlimited participation below 10.73 EUR/NOK Spot at expiry – Zero Cost Source: Danske Bank 6 Comparison of the strategies Source: Danske Bank Danske Source: 10.07 Bought Call option Call 10.2750 10.9 10.8 Reversal Risk 10.7 10.6 10.5 10.4 Effective Effective rate 10.3 Participating 10.2 10.1 10 Forward 10 11 10.2 10.4 10.6 10.8 10.96 10.04 10.08 10.12 10.16 10.24 10.28 10.32 10.36 10.44 10.48 10.52 10.56 10.64 10.68 10.72 10.76 10.84 10.88 10.92 EUR/NOK at expiry 7 Why use options Uncertainty in cash flow – In case it is difficult to predict cash flows, you are forced to maintain a low hedge ratio if you use forwards only, as there might be a risk of over hedging. Use less-committing options to maintain a high hedge ratio. If Carry cost is high, so the forward transaction seems unattractive – In case the interest rate difference becomes very high, it might be a good idea to use an option contract, where there is a chance you will not have to realize the carry cost. Market level is unattractive – In case your hedging policy requires you to hedge now, but the market is not favourable, you can use options to participate in a favourable market move. Other considerations when hedging with options – A flexible hedge mandate with the opportunity to both sell and buy options adds more dimension in relation to optimizing cost. – Active risk management: it is rarely optimal to hold options until maturity 8 When is Forward hedging (carry) expensive? Carry trades: high yield is like candy for speculators Carry trade is a well know investor strategy An attempt to systematically earn the +0.15% -0.55% interest rate differential between currencies (countries): Buy high yielding currency Sell low yielding currency You will gain as long as the high yielding currency doesn’t depreciate as much as the interest rate parity suggest. Systematic risk premium? 10 Risk Reversals (options) versus FX Forward Example Source: Danske Bank Danske Source: : 3M Forward 3M Forward 10.548 Sell put Selloption Strike 10.40 EUR/NOK EUR/NOK Spot 10.53 Buy Buy example c all option Strike 10.8250 (EUR (EUR 10.9 10.8 buyer 10.7 10.6 ) Effective Effective rate 10.5 10.4 10.3 10 11 10.4 10.2 10.6 10.8 10.56 10.72 10.88 10.04 10.08 10.12 10.16 10.24 10.28 10.32 10.36 10.44 10.48 10.52 10.64 10.68 10.76 10.84 10.92 10.96 EUR/NOK at expiry 11 Risk Reversal – difference between put and call options EUR/NOK Option smile (3M) 11.50 % 11.00 % 10.50 % 10.00 % 9.50 % 9.00 % Call: 9.13% Put: 7.92% 8.50 % Call-put: 1.21% 8.00 % 7.50 % 0 Put10 options20 30 40 50 60 70 Call80 options90 100 Protection against Protection against weaker EUR weaker EUR Source: MacroBond & Bloomberg 12 Example: Simulating and testing performance: EUR buyer 12.7512.75 EUR/NOK 12.5012.50 12.2512.25 12.0012.00 Buy EUR 11.7511.75 at 10.825 11.5011.50 11.2511.25 11.0011.00 10.825 10.7510.75 Buy EUR 10.548 10.5010.50 at spot 10.40 10.2510.25 10.0010.00 Buy EUR 9.759.75 at 10.40 95% conf. int. 9.509.50 Dec-19Dec-19 Mar-20 Jun-20 Oct-20 Source: Danske Bank & Bloomberg 13 “The rule”: EUR/NOK Buyer (1Y tenor) Source: MacroBond & Bloomberg 14 “The rule”: USD/NOK seller (1Y tenor) Source: MacroBond & Bloomberg 15 Hedge Instrument Guide Find the optimal hedging instrument based on carry and volatility Change in market – change in instrument Not one hedging instrument is suitable under all market conditions 17 Choice of Hedging Instrument (Currency Seller) Spot View Hedge Ratio Carry Cost Instrument Expensive Options Bullish Low Neutral Options Cheap Options/FX Forward Expensive Options Medium Neutral FX Forward Neutral Cheap FX Forward Expensive FX Forward/Options High Neutral FX Forward Bearish Cheap FX Forward 18 Choice of Hedging Instrument (Currency Buyer) Spot View Hedge Ratio Carry Cost Instrument Expensive FX Forward/Options Bullish High Neutral FX Forward Cheap FX Forward Expensive Options Medium Neutral FX Forward Neutral Cheap FX Forward Expensive Options Low Neutral Options Bearish Cheap Options/FX Forward 19 Which instrument to use? EUR Seller • Spot is expensive • Receive carry • Skew is favorable for EUR EUR Buyer • Spot is expensive • Pay carry • Skew is unfavorable for EUR Source: MacroBond & Bloomberg 20 Choice of Hedging Instrument – Bearish View (EUR Seller) Spot View Carry Cost* Risk Reversal Instrument Favorable FX Forward Receive Neutral FX Forward Bullish Carry Unfavorable FX Forward Favorable FX Forward Neutral Neutral Neutral FX Forward Unfavorable FX Forward Favorable Risk Reversal/FX Forward Bearish Pay Carry Neutral FX Forward/Risk Reversal Unfavorable FX Forward/Risk Reversal * You can use Danske Banks ”Carry/Risk Reversal” analysis” 21 Choice of Hedging Instrument – Bearish View (EUR Buyer) Spot View Carry Cost* Risk Reversal Instrument Favorable Risk Reversal Receive Bullish Carry Neutral Risk Reversal Unfavorable Risk Reversal/FX Forward Favorable Risk Reversal Neutral Neutral Neutral Risk Reversal Unfavorable Risk Reversal Favorable Risk Reversal Bearish Pay Carry Neutral Risk Reversal Unfavorable Risk Reversal * You can use Danske Banks ”Carry/Risk Reversal” analysis” 22 Summary Know your risk! Strong financial policy which is aligned with overall business objectives The choice of hedge instrument (Forwards versus options) depends (among others) on: Your business – Cash uncertainty – Nature of business and cash flow – Competition Market conditions – Carry (interest rate differential) – Volatility Next time – Part 3: Accounting and currency hedging by Arne Kristian Hokholt 23 Questions? 24 General Disclaimer This presentation has been prepared by Danske Bank A/S. It is provided for informational purposes only and should be viewed solely in conjunction with the oral presentation provided by Danske Bank and/or Danske Markets Inc. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e.
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