FX
OPTIONS STRATEGY of the cost of the forwards, once more including premium and bid-offer costs. Additionally, in case the cheaper option hedges provided poor protective qualities, we examined the hedge cash flows in the worst ever depreciation periods for the EM currencies. In the vast majority of cases, the option hedges provided similar protection, to about 90% of the level provided by the forward contracts. While remaining vastly cheaper, they still deliver value during high risk times.
Figure 3: Average cash flow for 3 month hedges of positive EM FX exposure
Source: Bloomberg and Commerzbank
Now is the perfect time for the financial world to review this situation. Increased scrutiny and regulation mean that global markets have an urgent need to increase fairness and transparency, and to be seen to be doing so. We are overdue a change of attitude. Hedging with options Some of this historical data analysis has yielded fascinating results with important implication for hedgers. In figure 3, we show the average results of hedging various Emerging Markets FX exposures. In this case the exposure to the EM currency is positive, ie, the risk is from depreciation of the EM currency. Because the forward rate always locks in a degree of depreciation which rarely actually occurs, these hedges are costly. On average, the quarterly forward hedges cost 6% of the notional amount per year; a very large expense. But, the difference between forward and option hedges is unambiguous – even including the full premium and bid-offer costs, the options cost on average is just over half of the 66 FX TRADER MAGAZINE July - September 2015
forward cost. Twenty out of the twentyfive currency pairs tested have the option cost as less than the forward cost, and the five exceptions have smaller data sets. In the past at least, options have delivered far cheaper hedges. We repeated the backtest using 25-delta out-of-the money long call option positions. We found that the supposedly more exotic OTM options are actually cheaper hedges again than both the ATMF options and the long forward contracts. In this case they are on average about one third
Thus a look at the historical data reveals that at least some hedging strategies can be revolutionised by the appropriate choice of contract. It is not the case that options are a universal panacea; if the exposure were negative (for example if there was a future liability in the EM currency) then forwards would have been a better choice. How about a trading strategy? If there are anomalies and biases in the FX option market, it is natural to wonder whether they may be used to generate returns. Investors like hedge funds, pension funds and insurance companies
Figure 4: Cumulative returns in % notional amount for 1W call selling in USDJPY
Source: Bloomberg and Commerzbank