The foreign exchange market is widely appreciated to be the largest and most liquid market of all global financial markets.  However, it is susceptible to shocks which can cause significant unexpected volatility, such as the timing of the Swiss National Bank’s (SNB) decision to remove its 1.20 floor on the Swiss Franc versus the Euro on 15th January 2015. Following the SNB announcement, the Swiss Franc immediately gapped stronger across the board as EUR/CHF fell some 30%, from 1.2010 prior to the announcement to a low of 0.8500. With it, the USD/CHF exchange rate fell over 25%, from 1.02 to below 0.74 cents, before stabilising. In this article we examine the effects of this volatility on investors with long USDCHF FX Forward exposure compared to those with long USDCHF FX Options exposure.

Millennium Global Investments has long recommended that foreign exchange mandates allow the use of both forwards and options. FX options are a valuable tool to express directional foreign exchange views to extract alpha from currency markets or to hedge portfolio exposures. The premium cost inherent in the purchase of an option delivers an asymmetric pay out profile of potentially unlimited gains and only limited losses.

A position in the spot or forward market by comparison has no premium cost attached and offers a symmetric payout profile; there is potential for gains or losses of equal magnitude.

The example below illustrates the significant risk management advantage of a long USD/CHF position held over the SNB announcement via a long USDCHF call option versus a long USDCHF forward position in limiting losses.

Historical Bloomberg data estimates the cost of a 1-month at the money forward (ATMF) USD call at 1.25% purchased on 14th January 2015 ; the day before the SNB announcement. The potential loss on the trade was dramatically less than in an equivalent delta exposure held through an FX forward. Indeed, the mark-to-market loss on the FX option was limited to the upfront premium. The delta of the position automatically reduced as spot USD/CHF spot fell.

On a theoretical USD 100m notional option, with a USD 50m delta equivalent exposure at inception, the maximum loss would have been USD 1.25m (USD 100mx 1.25%).

The potential loss on the equivalent delta FX forward position would have been significantly higher. For example, at an FX rate of 0.8500 on 15th January, following the SNB announcement, the mark-to-market loss on a long USD 50m FX forward position would have been USD 10m ((1.02-0.85)*50m)/0.85); eight times the potential loss in the FX forward versus the FX option.

The difference in impact between holding a USDCHF call option versus a USDCHF forward contract (which take the same currency exposure as a starting point) is very substantial.  The benefits of using currency options as part of exposure risk management in an international portfolio has been brought into focus by the actions of the SNB on 15/1/15.

USD/CHF FX Option vs. FX Forward scenario analysis

  • Trade date: 14th January 2015
  • USD/CHF Spot 1.0205

FX Option

  • Long 1.0200 strike (ATMF) 1-month (expiry 13th February, value 17th February) USD call/CHF put
  • Notional USD 100m / delta equivalent long USD50m
  • Implied vol. 10.95%
  • Premium 1.25% USD notional
  • Maximum profit: Unlimited above 1.03275 breakeven at expiry
  • Maximum loss: 1.25% premium paid (USD 1.25m)
USD CHF Through Options

Source: Bloomberg, 20 January 2015

FX Forward

  • Long USD 50m vs. CHF at 1.0200 value 1-month 17th February 2015
  • Maximum profit: Unlimited above 1.0200 forward price
  • Maximum loss: Unlimited
USD CHF Through Forwards

Source: Bloomberg, 20 January 2015

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