One positive outcome from the last quarter-century of market disruptions, including the recent volatility of currencies due to globalisation and economic instability, has been the emergence and increasing use of foreign exchange options to hedge against losses, mitigate risk and seek returns on investment.
It’s been no small outcome. The FX option market has grown exponentially in the last 35 years. According to the latest survey of foreign exchange market activity conducted by the Bank for International Settlements*, the daily average flow of FX options has gone from roughly USD 1 billion in 1995 to nearly USD 300 billion in 2013.
FX options confer the right—but not the obligation—to buy or sell a position in a currency at the strike price during a given period of time or on a specific date. This optionality gives rise to the possibility of investors benefiting irrespective of the direction of currency movements. In the corporate world, treasurers may choose to hedge currency risk through the purchase of a call or put option.
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Multinational corporations with overseas operations stand to gain the most from FX option strategies, with China’s sudden devaluation of its currency on August 11 2015 highlighting the importance of risk mitigation. Still, despite their growing popularity, the underlying facts and ways of thinking about these options remain under-reported. The key to applying them to best advantage is to understand their history, how they work and are priced and how they’ve performed at various points and in different markets over time.
“The equations that underlie the pricing of options, which were the first real mathematical definition of market volatility, were the same equations Einstein used to explain the movements of atoms in a gas,” notes Jessica James, Senior Quantitative Researcher at Commerzbank Corporates & Markets, who also co-authored the book FX Option Performance. “What’s not well known is that those same equations were published four years earlier, in 1900, by Louis Bachelier in Paris to explain the movements of the stock market.”
In 1973, Fischer Black, Myron Scholes and Robert Merton adapted the mathematics to a model for predicting FX market movements. It consists of the current price of an asset, the strike or exercise price, interest rates, the expiration date and implied volatility. While “historical volatility” is based on recently witnessed prices, “implied volatility” gives an expectation of the volatility that might be realised in the future and is the more important component of FX option valuation. If currency markets are expected to be choppy, then the implied volatility will be high, resulting in a higher option price due to the higher probability of a large payout if FX rates move strongly.
Currency risk appeared as countries began to abandon the fixed post-war FX rates in the 1970s and as corporations increasingly had income and liabilities denominated in foreign currencies. Seeking to minimise volatility, corporate treasurers first used forward FX contracts which lock in an exchange rate for some future date. As globalisation gathered momentum, however, corporations increasingly found that they had currency risk related to emerging economies where interest rates are typically considerably higher. By locking in a forward price, treasurers found themselves effectively paying a high cost of carry with each forward hedge entered.
FX options became popular a decade later, offering corporates an alternative hedging instrument. They were slow to adopt the derivatives, however, possibly due to their perceived complexity and upfront cost.
A persistent problem was that there had never been a systematic measurement of option costs or payouts over time—data necessary for treasurers to make an informed decision.
In order to base a hedging decision on the performance of different strategies, a company may consider historical data that systematically compares the performance of forwards versus options—spanning different time periods and market regimes. Despite the wealth of material on option pricing models, until recently the ultimate value provided by options has not been studied in anywhere near as much detail.
While treasurers of companies with overseas operations, especially in emerging markets where yields tend to be higher, are the most likely beneficiaries of FX options, hedge fund managers and private investors can also gain from knowledge of option strategies and long-running patterns of pricing and payoffs. For them, FX Option Performance might well become required reading.
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*Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013; February 2014
By Bloomberg Custom Content
For more information, contact FX Volatility at Commerzbank.
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