COMBINING
DERIVATIVE PRODUCTS COMBINING
DERIVATIVE PRODUCTS
One aspect of financial engineering that leverages the power of derivative products in a simple, elegant fashion is the combination of existing derivative products. Let's consider a few of these different combination products that can contain vanilla products, exotic products, products from different asset classes or just about any other pairing that one can imagine. In all of the following examples, I will use foreign exchange as the asset class for the sake of simplicity. It is just as easy to extend this to equities or fixed income or commodities. The actual strikes involved are contrived in order to demonstrate the behavioral characteristics of the products in question.
The Straddle
Let's consider the case where spot USD/JPY (i.e. the number of Japanese Yen per 1 US dollar) is at 115. The month is February. From our analysis, we have come to believe that spot USD/JPY is ready for a breakout in the month of April, following the Japanese fiscal year-end. Or, at least, spot USD/JPY could be in for some real volatility. This is predicated on the view that Japanese corporations and investors, having placed money offshore to take advantage of better investment opportunities abroad, will repatriate these funds for fiscal year-end only to send them offshore again after closing the books. We also know that the US trade representative is conducting a review of improvements to Japanese trading practices and that she will present this report to Congress in early March. This report is likely to highlight tensions relating to the burgeoning US trade imbalance with Japan (and the rest of the world). The US government may seek to "jawbone" the dollar lower in order to improve the US terms-of-trade.
Spot USD/JPY could follow a roller-coaster over the next few months. Going much lower before going much higher. If we buy an at-the-money-spot 115 USD Call/Japanese Yen Put and we simultaneously buy an at-the-money-spot 115 USD Put/Japanese Yen Call on the same notional amount of $10 million US dollars and for the same expiry date of May 1, we have purchased a straddle on the USD/JPY. If spot is volatile with the volatility centered around the strike of 115, we stand to make a great deal of money by trading the delta (not to mention the increases in value from hikes in implied volatility) of this combination of options.
The Strangle
Instead of purchasing options with the same expiry date, notional amount and strike, we could have varied the strategy by buying two out-of-the-money options. For example, we could have purchased simultaneously a May 1 130 USD Call/JPY Put and a May 1 100 USD Put/JPY Call. Compared to the straddle, this strategy is cheaper, although we have to be careful when we are hedging the delta around the expiry that we are not left with a cash position that is unlikely to make money. For example, let us suppose that at expiry, spot is at 122 and from our delta hedging activities we are short US dollars against Japanese Yen. We must be sure to close out this position as soon as the options are expired if we do not have a firm view that the US dollar will weaken. Too often, traders will not be disciplined in managing positions that are created by their delta-hedging activities.
The Risk Reversal
Consider now the corporation that is hedging their exposure to a move higher in the US dollar against the Euro. Spot EUR/USD (i.e. the number of US dollars per 1 unit of the Euro) is quoted at $1.1335. They have a firm commitment to buy a factory in Germany in three months' time that will cost them Euro 10 Million. They are exposed to fluctuations in the EUR/USD exchange rate because they are a US-based company reporting their profits in US dollars.
The first hedge that comes to mind (and the one often chosen to benchmark risk management performance) is the forward outright. They could buy Euros against US dollars for delivery on the same date that they need to make the payment from their account for a rate of $1.1294. However, they think that there is a possibility that the European Central Bank will not lower interest rates for at least six months, contrary to market expectations, and so the Euro could drift higher against the US dollar (i.e. EUR/USD could trade slightly lower).
Therefore, they enter into a risk reversal. They buy an out-of-the-money Euro call/USD put (with a strike of $1.15 against selling an out-of-the-money Euro Put/USD Call with a strike of $1.11 for zero cost. How does this work at expiry? If spot settles above $1.15, the corporation will exercise their Euro call and buy Euros at $1.15. If spot settles below $1.11, they will be exercised on their Euro put and they will consequently buy Euros at $1.11. Anywhere in between $1.11 and $1.15 and neither option is exercised, with the corporation buying their Euros at the market rate in the spot market. This structure is sometimes called a range forward because it enables the corporation to lock in a range within which they know with certainty that they will be buying Euros while giving them the flexibility of gaining from a small movement in their favour in the currency pair.
Beware of Geeks Bearing Gifts
Banks have made a lot of money from this structure and others like it because they have encouraged corporations to enter into hedges with no obvious upfront cost. Many Treasurers believe that there is no reason to buy an option, that options are products that should only be sold. This has worked to the advantage of the banks because like every other market, there are times to buy options and there are times to sell options. When they need to buy options, corporate Treasurers are flooded with these so-called "zero cost" alternatives.
Other times, as we shall see, zero cost strategies have costs embedded in them that are not obviously transparent to the user. Some sophisticated market participants can discern the true cost nevertheless and still proceed, believing that these structures are appropriately priced. Of course, not everyone is a sophisticated market participant. And sophistication like any other valuable commodity comes with a price.
The Trigger Forward
Consider now a currency pair that is only going in one direction. Think of the New Zealand dollar against the US dollar during much of the Asian crisis. This was a "gimme" as far as most market observers were concerned, bar the odd correction. It was only going to go down. The economy was heavily dependent upon exporting commodities to mainly Asian countries. And the Minister of Finance was a man with no experience in monetary or fiscal affairs who had a known propensity for getting into the newspaper for all of the wrong reasons.
Again, the simplest strategy might have been to sell NZD/USD (i.e. the number of US dollars per 1 unit of the New Zealand dollar) on a forward outright basis. If spot NZD/USD was at 0.6400 and the forward outright was 0.6362 for six months' time, then that meant that holding the period for six months had a funding cost. If spot NZD/USD stayed at 0.6400, the trader would be out 0.0038 points on whatever actual amount they traded. Instead they could have done the following, taking advantage of nervously high NZD/USD implied volatilities. They could have bought a six month NZD put/USD call struck at 0.6510 which knocked out if 0.6510 traded before the option expired and simultaneously sold a six month plain vanilla NZD call/USD put struck at 0.6510. The combination of the two options would cost nothing at inception. The higher the implied volatilities involved the higher the strike would be in reference to spot because the trader here is net selling volatility.
If NZD/USD went straight down, without touching the knockout option's trigger at 0.6510, the structure would have made more money for zero cost at inception than he would have on the forward outright in consideration for taking the risk of being short a potentially dangerous option without protection. One can see that structures can be developed that not only address a given view but also a specific tolerance for risk.
The Range Binary
Finally, let us consider the range binary, a structure that pays out a lump-sum if spot stays within a specific range without trading at either level in exchange for the payment of a relatively small upfront premium. Let's say that we are looking at USD/CAD (i.e. the number of Canadian dollars per 1 unit of the US dollar). We believe that USD/CAD is stuck in a range between 1.50 and 1.55 for the next two months. How do we take advantage of this view? We could buy simultaneously a double barrier USD call/CAD put with a strike of 1.50 that knocks out at either 1.50 or 1.55 and a double barrier USD put/CAD call with a strike of 1.55 that knocks out at either 1.50 or 1.55. If spot stays in the range without triggering either 1.50 or 1.55, we will make 0.0500 on the notional amount of the options. The options themselves are relatively cheap because they are so likely to be knocked out. The higher the implied volatility, the more likely they are to get knocked out, the cheaper these structures.
Summary
We have looked at just some of the different types of combinations of derivatives that are possible. Indeed, the proliferation of derivative products means that the tailoring an exposure to a particular view and tolerance for risk is getting easier all the time.
Article by Chand Sooran, Principal, Victory Risk Management Consulting, Inc.
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