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
- 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)
- 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
This information is provided for information, illustration and education purposes only, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. This document (including the information provided herein) does not constitute an offer to buy or a solicitation of an offer to sell any securities or interests and does not constitute an offer or solicitation of any kind in any jurisdiction in which such an offer or a solicitation would be unlawful or to any person to whom it would be unlawful.
The information contained in this document is subject to change at any time without prior notice, and Millennium is under no obligation to issue updates hereto. Millennium specifically disclaims all liability for any direct, indirect, consequential or other losses or damages including loss of profits incurred by you or any third party that may arise from any reliance on this document/report/model or for the reliability, accuracy, completeness or timeliness thereof. Millennium accepts no liability for losses arising from the use of this material.
This information is not intended to be complete or exhaustive and there is no guarantee that any information laid out herein would be successful in wholly or partially mitigating such risk. You should consult your tax, legal, accounting or other advisors about the matters discussed herein.
Certain accounting assumptions have been made and some unreconciled and/or estimated values used in compiling this report, reasonable people may disagree with the assumptions used and expectations developed there from (estimated data should not be relied upon as it is based on unreconciled data and therefore subject to change). Distribution of this information to any person other than the person to whom this information was originally delivered and to such person’s advisors is unauthorised and any reproduction of these materials, in whole or in part, or the disclosure of any of the contents, without the prior consent of the Millennium in each such instance is prohibited.
This material is directed exclusively at persons who are experienced or existing investors in unregulated collective investment schemes, who are professional clients as defined by the rules of the Financial Conduct Authority (“FCA”) or are otherwise eligible under these rules.
Millennium Global Investments Limited, an English company, and the investment manager (“Investment Manager”) of Millennium Global Currency Products is authorised and regulated by the Financial Conduct Authority and registered as an investment adviser with the Securities and Exchange Commission and will invest in and actively engage in transactions in instruments with significant risk characteristics. Registration with the SEC does not imply a certain level of skill or training. The Investment Manager and the Product shall be defined as “Millennium” for purposes of these disclosures.