Strategy Trumps Forecasting: The Risk Reversal (or FX Collar)

Posted by Alexander Grant on 3/18/21 8:23 AM

There is a common presumption in capital markets and trading that proper risk management involves having to correctly forecast markets. The #1 question I have received working on both the buy and sell side of the trading industry is:

"Where do you think the market is going?"

The recurrence of the question is interesting as it points towards the tendency of humans to seek more certainty about the future. However, in reality proper risk management can have little to do with forecasting if you are equipped with the right strategies and knowledge.  

For example, it is well-known that diversification reduces overall portfolio risk. A portfolio manager need not forecast the direction of each stock in a portfolio to reduce risk of adverse performance. He/she must merely add enough low-correlated stocks to the portfolio. Asset managers leverage powerful risk management principles and strategies like this to reduce risk.

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Source: https://seekingalpha.com/article/4284929-delicate-art-of-balancing-diversification-and-concentration 

 
Corporate FX Programs- Example of the Risk Reversal (or FX Collar)

 

For corporate FX hedgers the situation is more nuanced.

Unless you are the Treasurer of a large multinational doing business in a basket of global currencies, most corporates are unable to benefit from the advantages of currency diversification. In many cases companies are trading in less than 5 currencies, and often in just 1 or 2.

So, this naturally brings to mind the question:

“How do I improve my FX program without having to forecast the currencies I trade in?”

There are many ways to address this, but one of the main tenets of optimizing an FX program is: The ability to adjust a hedge and transfer risk away.

 
Adjusting a Hedge to Transfer Risk Away

 

Let’s work through an example.

Assume 6 months ago you hedged a 500K USD receivable via outright FX forward out 1 year at USDCAD = 1.4000 (i.e. 6 months remaining in forward). The current spot rate is 1.2600. This represents a positive unrealized gain on the forward of (1.4000 – 1.2600) x $500,000 = $70,000 CAD

The risk profile of a SELL USD outright FX forward at 1.4000 looks as follows:

Risk Profile of SELL USDCAD Forward at 1.4000

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Many corporate FX hedgers would simply take the hedge into expiry and settle the $500,000 USD at 1.4000. However, a lot can happen between now and the expiry of the forward in 6 months.  

One strategy that can be used to monetize/protect the unrealized gain ($70,000 CAD) is the risk reversal (or FX collar). This is a zero-cost structure which does not require outlay of premium. The mechanics are as follows:

  • BUY 500K USD Call/CAD Put at a strike above the spot rate (i.e. above 1.26)
    AND
  • SELL 500K USD Put/CAD Call at a strike below the spot rate (i.e. below 1.26)

For example, we could BUY 1.2800 USD Call/CAD Put, and simultaneously SELL 1.2400 USD Put/CAD Call, all for even money ($0.00). As the name suggests, the risk reversal (or FX collar) reverses the risk. The structure by itself looks as follows:

Risk Profile of 1.28/1.24 USDCAD Risk Reversal (or FX Collar)

image001

When you combine the forward + risk reversal this yields:

Risk Profile of Forward + 1.28/1.24 USDCAD Risk Reversal (or FX Collar)

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The most important part of this process is that you have removed all risk (from a mark-to-market standpoint). Also, we have monetized/protected the majority of the $70,000 CAD unrealized gain – all without an outlay of capital!

While the combined forward + risk reversal continues to increase in value (from MtM standpoint) should USD weaken further, the mechanics at expiry are as follows:

Scenario 1:
  • If spot rate > 1.2800 (call strike)
    • Exercise call (BUY USD at 1.2800)
    • Exercise forward (SELL USD at 1.4000)
    • SELL 500K USD at spot rate
    • Best case scenario
Scenario 2:
  • If 1.2400 (put strike) < spot rate < 1.2800 (call strike)
    • Risk reversal expires worthless
    • Exercise forward (SELL USD at 1.4000)
Scenario 3:
  • If spot rate < 1.2400 (put strike)
    • Call expires worthless
    • Auto-exercise put (BUY USD at 1.2400)
    • Exercise forward (SELL USD at 1.4000)
    • SELL 500K USD at spot rate
    • Worst case scenario

The net effect in all 3 scenarios is still selling $500,000 USD into CAD. The difference becomes the effective (or net) rate at which those funds are exchanged.

In Scenarios 1 and 2, the net forward rate is >= 1.4000, and <= 1.4000 in Scenario 3.

So, in 2 out of 3 scenarios you replicate or exceed the original forward rate (1.4000). All while eliminating risk from the structure. On a risk adjusted basis this is a huge advantage.

This is not a full proof strategy, but I hope the principles of thinking along these lines are helpful.

Until next time…

Alex


Alexander Grant, FRM is Olympia Trust CGP’s Head of FX Options Trading. He can be reached at granta@olympiatrust.com or 1.866.927.7774.

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