|
|
Wednesday, 24th April 2024 |
| Innovative foreign exchange structures for Irish treasurers |
Back |
| Alan O'Neill examines a range of innovative foreign exchange structures now available to Irish corporate treasurers, including the 'soft KI forward, and the 'fader forward', which compares favourably against the more traditional KO forward. |
Bank of America Global Foreign Exchange (GFX) team provides clients with a currency risk management service precisely tailored to their needs. We believe our innovative approach in terms of product development and the stress-testing of hedging structures is a true differentiator in how Bank of America structures solutions that best serve our clients.
Following a review meeting with the treasury division of an Irish based corporation, we investigated their potential FX exposures and advised them in terms of the risk management of those positions. Given the nature of its business, our client faces FX exposures originating principally from production and material costs in the US.
Thus, the client's objective was to protect the euro cost of USD denominated expenses and ultimately, outperform the predefined budget rate. The client's budget rate for 2007 was 1.3175 and at the time spot Eur/Usd was trading around the 1.3250 level. The treasury committee of the company held the view that Eur/Usd was heading higher over the course of the year and would range from 1.2900 to 1.3800. The proposed strategies were aimed at providing protection against adverse spot movements whilst participating in a slightly bullish spot move.
Recommended strategies
The soft KI forward can be seen as an alternative to the more classic at maturity forward extra; it makes use of variable notional options to smooth-out the digital risk associated with the forward extra. Hence, the associated barrier can be 'pushed' further away, allowing the client to benefit further from potentially advantageous spot moves.
A variable notional option is one whose notional at expiry is dependent on the spot fixing at expiry relative to the original strike and the soft barrier. In a similar fashion to a European style barrier, soft barriers are only observed at expiry.
Trade details (indicative terms & conditions)
Client's Position: Sell Eur/Usd Forward
Expiry: 6 months
Initial Notional Amount: €10,000,000
Strike (K): 1.3175
Soft KI (SoftKI): 1.4250
Final Notional Amount:
‚ If spot Eur/Usd fixes at or below 1.3175;
410,000,000
‚ If spot Eur/Usd fixes above 1.3175;
€10,000,000* (Smat - K)
(SoftKI - K)
Smat: Eur/Usd spot exchange rate as observed on Reuters page ECB37 on the expiry date
Analysis: The client is fully protected against a downward move in Eur/Usd below the 1.3175 strike. In addition, in the event that spot Eur/Usd at expiry fixes above the strike rate but below the soft knock-in level, the client will only be required to sell euros in a notional amount that is proportionate to how close the fixing is to the soft KI level. Above the soft KI level, the client will be required to sell euros at the conversion rate for the initial notional amount.
Spot Ref.: 1.3250
6m Fwd Ref.: 1.3310
The soft KI forward can be compared to an at-maturity forward extra and or a P participating forward. For comparison and analysis purposes, we will now study the more classic at-maturity forward extra.
The at-maturity European forward extra strategy provides the client with protection against a strengthening Usd whilst offering the ability to participate in a potential depreciation of the greenback.
Trade details (indicative terms & conditions)
Client's Position: Sell Eur/Usd Forward
Expiry: 6 months
Notional Amount: €10,000,000
Strike (K): 1.3175
KI Barrier: 1.3850 valid at expiry only
Analysis: At expiry, the client has the right to sell Eur/Usd at the rate of 1.3175. In addition, the client can participate in a potential appreciation of the Eur up to the 1.3850 valid. That is, if spot Eur/Usd at expiry fixes between 1.3175 and 1.3850, the client has no obligation to sell euro at 1.3175 and can sell at the prevailing market rate. Only if at expiry spot Eur/Usd fixes above the 1.3850 level will the client have the obligation to sell euro at 1.3175.
The at-maturity forward extra can be decomposed into (see graph 1):
- Long a Eur put/Usd call 1.3175
- Short a Eur call / Usd put 1.3175 European knock-in 1.3850
In comparison, the soft KI forward consists of (see graph 2):
- Long a Eur put / Usd call 1.3175
- Short a Eur call / Usd put soft KI 1.4250
To better understand the difference between the soft KI and the forward extra, we have plotted the residual optionality. We notice that the variable option notional allow to benefit from a potential appreciation of the Eur beyond the 1.3850 KI level. The digital type risk at 1.3850 has now disappeared, and the potential gain is now spread over a wider range. The euro KI forward performs better in case of limited euro appreciation, while the soft KI forward will grant a milder participation to the euro appreciation and pushes the benefit to encompass a larger move before actually forcing the customer to respect his original engagement at the conversion rate.
The structure shown in graph 3, allows the client to be fully hedge whilst participating in advantageous market moves. The strategies are easy to implement and combine both simplicity and flexibility. Thus, offering good economic value as well as a perfect hedge and favourable accounting treatments.
A different approach
A different approach, which allows the client to fix an 'advantageous' exchange rate from the offset, relies on the use of accrual or fader options. A fader forward enables the client to secure an exchange rate that outperforms the prevailing outright forward. The uncertainty is transferred to the notional of the contract to be exchanged at expiry.
In fact, the notional of a fader forward accrues to the pro-rata number of observed fixings that meet a pre-defined condition.
Trade details (indicative terms & conditions)
Client's Position: Sell Eur/Usd Forward
Expiry Date: 6 months
Strike: 1.3460 Usd per Eur
Fade-In Level: 1.2890 USD per EUR
Notional: €1,000,000 n
Where: n is the number of weekly fixings above the 1.2890 fade-in-level
In the event that spot Eur/Usd ever trades at or below 1.2890, the accumulation process will stop.
Observation Period: 26 weekly observations (ECB37)
Maximum Notional: €26,000,000 if Eur/Usd spot always trades at or above 1.2890
Analysis: Over the 6-month life of the trade, for every week that spot Eur/Usd fixes above the 1.2890 Fade-In level, the client sells €1,000,000 at the rate of 1.3410 for delivery 6 months (from Trade Date). Outperforming the 1.3310 outright forward by 150 pips. In the event that spot Eur/Usd ever trades at or below 1.2890, the accumulation process will stop and the client will retain the accrued notional to date.
The fader forward compares favourably against the more traditional KO forward. Firstly, the notional accrued at the pre-agreed strike is fully retained by the client. In addition, as we approach the fade-in level, the fader forward retains a fair amount of value and therefore, can be restructured. The fade-in barrier softens the 'digital' risk associated with the KO barrier and allows for a better monitoring of the position.
Overall, fader type structures are extremely flexible and allow for an easier management of the position. They offer economically viable hedging alternatives. The fade-in barrier described in the above product is referred to as 'extinguishing'; in that the accumulation process ceases in the event that the fade-in level is triggered. We can modify the nature of the barrier from 'extinguishing' to 'resurrecting'. In which case, the barrier is only monitored on the weekly fixing date for that fixing only. Every fixing is fully independent. |
Alan O’Neill is vice-president of corporate treasury in Bank of America.
|
| Article appeared in the May 2007 issue.
|
|
|
