| Математика
Key words: Risk reversal, Collar, Range forward, Seagull, Participating forward
FX strategy

In the previous article, a large EU company exported to the USA and got payment in US dollars.
If the company expects a stronger EUR/USD in the future which strategy to use in order to eliminate FX exposure?

One simple possibility is to buy a call option on EUR/USD but it appears too expensive. How to cheapen it?

Another possible solution is to buy FX forward but this forward has a downside risk.
Let’s see how the primary goal can be achieved with some popular FX strategies.

1. The range forward (risk reversal and collar)

1.1 Risk reversal is a zero-cost strategy assuming a combination of a long call position and a short put (or vice versa) with different strikes.
This is one of the most basic and conservative forward hedges available for corporates.

The company can use a zero cost strategy by financing the call with the sale of a put. Both options are out of the money (OTM).
It is easy to show that the client’s FX risk is locked within a “range” but there is a downside if USD going to be stronger and in the same time this strategy provides full protection against EUR rising.
The risk is said to be reversed and that’s why the strategy often called Risk Reversal.

FX risk Reversal

As can be seen from the picture, if the expectation is correct, the company can buy EUR at maturity at the strike of 1.0930.
The risk exists when the market is below the strike of 1.0770 at maturity and the company is obliged to buy weaker EUR.

This Risk reversal looks almost identical to the straight long FX position except for the “range” between strikes of 1.0770 and 1.0930 where neither option is exercised. This range provides some margin of error and thus between two strikes at maturity the strategy ends up with zero PnL.

In this example the current spot rate 1.0850 EUR/USD is used as the starting point to obtain a zero cost strategy and OTM strikes are used to narrow or increase the “range” so long as the two premiums are equal.

It should be said that Risk reversal expresses the difference in volatility which is known as volatility skew. The implied volatility typically is greater for OTM puts than for OTM calls, OTM puts are expensive and OTM calls are cheap.

1.2 Collar

Risk reversal is said to be a forward with a range. What if an exporter doesn’t want to have a range but instead prefers to have a straight forward and somehow wants to limit the downside risk?
Collar strategy is suitable for this case.

Collar is what Corporates often mean by Risk reversal but this is not the same structure and it often confuses people.
In FX market where currency is the underlying, collar is:

long OTM put + short OTM call + long underlying (forward in our case) = short risk reversal + long underlying

Therefore, Collar is neither Risk reversal nor Short risk reversal.

The payoff assumes “to cap” and “to floor” the actual Profit/Loss from the FX underlying exposure (Collar is well known strategy in Interest rate market assuming cap and floor options to be held in the portfolio) as demonstrated below:

FX Collar

You can use the article to understand different options payoffs and how they are constructed so you can easily build the payoff for this Collar strategy.

The payoff can be different depending on the premiums of the options and the strike of the forward. If the OTM put premium is too high, the strike of the forward can be lower than the current market forward strike for the same maturity. This is because the premium from the sold call option can’t compensate the paid premium for the put.

The premium raised by the sale of a call exactly matches the cost of a put Option and thus this is also a zero-cost strategy.

What does this strategy means to an exporter? It simply has limited downside risk but upside exposure is also limited, i.e. if the current spot is around 1.0850 EUR/USD and the exporter believes that EUR/USD will be in the range of 1.0850 – 1.0930, then it worth buying the strategy.

2. Seagull

Risk reversal is said to be a forward with a range. What if an exporter likes risk reversal but wants eliminate partially the downside risk?
Seagull strategy is a right one with zero-cost benefit.
It became popular in the early 1990s as an extension of the risk reversal with the additional strike limiting the downside risk.

This is a three option combination requiring simultaneously selling an ATM put and buying an OTM call and an OTM put.
The purchases of the OTM options are financed by selling the ATM put. The payoff illustrates the idea:


3. Profit sharing forward

If exporters prefer to have a straight forward and somehow want to limit the downside risk, profit sharing forward is another suitable strategy.

This is a zero-cost strategy also known as a participating forward or as a ratio forward.
An exporter may not want to pay a premium and prepared to give up some of the benefit of a favorable exchange rate move.

The strategy is a two option combination with a long OTM call and a short in-the-money (ITM) put.
Both strikes are the same but notional amount differs in order to achieve a zero cost strategy.

If EUR/USD spot is 1.0850, the strategy assumes:

• Long OTM call with approx. 1.0910 strike on $1 million

• Short ITM put with the same strike on $0.5 million (50% participation)

If the rate is less than 1.0910 at maturity, the company will be obliged to sell $0.5 million at 1.0910 but can sell the remaining $0.5 million at the beneficial market rate.

Protected rate is always somewhat worse than that achievable with a normal forward but a downside is limited as well.

Participating Forward