Tag Archive for: hedging

Managing treasury risk: Commodity Risk (Part IV)

| 14-2-2017 | Lionel Pavey |

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my fourth article I will write about commodity risk, what the strategies around commodities are and how to build a commodity risk framework. More information about my first three articles can be found at the end of today’s article.

Commodity Risk

Commodity risk occurs due to changes in price, quantity, quality and politics with regard to the underlying commodities. This can refer to both the commodity as a whole and an input component of a finished good. Commodity risk usually refers to the risk in a physical product, but also occurs in products like electricity. It can affect producers, suppliers and buyers.

Traditionally, commodity price risk was managed by the purchasing department. Here the emphasis was placed on the price – the lower the price, the better. But price is only one component of commodity risk. Price changes can either be observed directly in the commodity or indirectly when the commodity is an input in the finished product.
Availability, especially of energy, is crucial for any company to be able to undertake operations. Combining commodity risk over both Treasury and Purchasing allows these 2 departments to work closer and build a better understanding of the risks involved. It also allows for a comprehensive view of the whole supply chain within a company. A product like electricity is dependent on the input source of production – gas, petroleum, coal, wind, climate – as well as the price and supply of electricity itself.

There are many factors that can determine commodities prices – supply and demand, production capacity, storage, transport. As such it is not as easy to design the risk management model as it is for financial products.

 General strategies that can be implemented

  1. Acceptance
  2. Avoidance
  3. Contract hedging
  4. Correlated hedging

Acceptance
Acceptance would mean that the risk exposure would be unchanged. The company would then absorb all price increases and attempt to pass the increase on when selling the finished product.

Avoidance
Avoidance and/or minimizing means substituting or decreasing the use of certain input components.

Contract hedging
Contract hedging means using financial products related to the commodity, such as options and futures as well as swapping price agreements.

Correlated hedging
Correlated hedging means examining the exposure of a commodity – the price of crude oil is always quoted in USD – and taking a hedge in the USD as opposed to the crude oil itself. The 2 products are correlated to a certain extent, though not fully.

Commodity risk framework

Commodity price speculation – most contracts are settled by physical delivery – affects the market more than price speculation in currency markets.
To build a commodity risk framework, attention needs to given to the following:

  1. Identify the risks
  2. Measure the exposure
  3. Identify hedging products
  4. Examine the market
  5. Delegate the responsibility factors within the organization
  6. Involve management and the Board of Directors
  7. Perform analytics on identified positions
  8. Consider the accounting issues
  9. Create a team
  10. Are there system requirements needed

Problems can arise because of the following:

  1. Relevant information is dispersed throughout the company
  2. Management may not be aligned to the programme
  3. Quantifying exposure can be difficult
  4. There is no natural hedge for the exposure
  5. Design of reports and KPI’s can be complex

It requires an integrated commitment from diverse departments and management to understand and implement a robust, concise policy – but this should not be a hindrance to running the policy.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist 

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Managing treasury risk: Foreign exchange risk

 

Managing Treasury Risk – Foreign Exchange Risk (Part III)

| 7-2-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my third article I will focus on foreign exchange risk. This risk has to be taken into consideration when a financial commitment is denominated in a currency other than the base currency of a company.
There are 4 types of foreign exchange risk.

Transaction Risk

Transaction risk occurs when future cash flows are denominated in other currencies. This refers to both payables and receivables.  Adverse changes in foreign exchange prices can lead to a fall in profit, or even a loss.

Translation Risk

Translation risk occurs when accounting translation for asset and liabilities in financial statements are reported. When consolidating from an operating currency into a reporting currency (overseas offices etc.) the value of assets, liabilities and profits are translated back to the reporting currency. Translation risk does not affect a company’s cash flows, but adverse changes can affect a company’s earnings and value.

Economic Risk

Economic risk occurs when changes in foreign exchange rates can leave a company at a disadvantage in comparison to competitors. This can affect competitive advantage and market share. Future cash flows from investments are also exposed to economic risk.

Contingent Risk

Contingent risk occurs when potential future work is expressed in a foreign currency. An example would be taking part in a tender for work in another country where the pricing is also in a foreign currency. If a company won a large foreign tender, which results in an immediate down payment being received, the value of that money would be subject to transaction risk. There is a timeframe between submitting a tender and knowing if the tender has been won, where a company has contingent exposure.

Identifying Foreign Exchange Risk

  1. What risk does a company face and how can it be measured
  2. What hedging or rate management policy should a company use
  3. What financial product, available in the market, should be best used
  4. Does the risk relate to operational cash flows or financial cash flows

Initially we need to ascertain what we think future FX rates will be. Methods that can be used include the Forward Rate Parity, the International Fisher Effect which also includes expected inflation, forecasts provider by banks and international forums, along with VaR. Model analysis can be provided, among others, via fundamental factors, technical analysis, and political analysis.

Different FX rates can then be used to simulate the effects on cash transactions when converted back into the base currency. This will provide different results that will allow a company to determine what level of risk it is prepared to accept. Finally a decision must be taken as to whether the company wishes to hedge its exposure or not. Before the advent of the Euro, both the Netherlands and Germany  were members of the Exchange Rate Mechanism (ERM). This meant there was agreed band within which the spot rate could move around an agreed central point – this was NLG 112.673 equal to DEM 100.00 with a bandwidth of +- 2.25%. For some companies, this tight band meant that they took the decision not to hedge any exposure between DEM and NLG.

Financial products that are commonly used to manage foreign exchange risk include Forward Exchange contracts, Futures, Caps, Floors, Collars, Options, Currency Swaps and Money Market hedging.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Option Tales: Cheap Options Part III

| 31-05-2016 | Rob Söentken

banking

 

Today in Rob Söentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. In the previous article I talked about choosing the longer tenor and the compound option. Today I will discuss the average rate option (ARO) and the conditional premium option.

Average Rate Option (ARO)

An Average Rate Option (ARO) can be misleading because it is like a vanilla option except for the reference rate against which it is exercised. The reference rate for an ARO is an average based on spot rates for USD taken at predetermined intervals. For a vanilla option it is the single rate for spot at maturity. If the intention was to hedge the rate for USD in 1-year time, the average of USD rates during the year is really something different.

If we would be looking to hedge a 1-year tenor and the averaging would be at quarterly intervals, a rough and quick estimate of an ARO’s cost would be the average premium of separate vanilla options for respective tenors, in this case that would be 0.9% (see diagram 3). Which would be considerably less than a vanilla option costing 1.50%.average rate option ARO
But unlike a strip of options which can be exercised individually, an ARO can only be exercised in total. At maturity the averaging of the fixings is mostly done, and it could happen that while the last fixing is In The Money (ITM), the average of the fixings is not, making the ARO expire worthless. In this example it would be advantageous to have a strip of vanilla options because each option would be exercisable independently of the other. The ARO on the other hand is worthless because the average would still be above the strike. This inherent risk in using an ARO will make the premium of an ARO even a bit cheaper than a strip of vanilla options.

The bottom line remains that the premium of an ARO is lower than a vanilla option for the same tenor, because the embedded tenor of the ARO is really shorter. The effect is comparable to paragraph 2 ‘Choose shorter tenor’. Slightly worse even when considering the averaging effect.

Conditional Premium Option

A Conditional Premium Option has the advantage over a vanilla option in that premium only has to be paid if the option is In-The-Money (ITM). But… if the option is ITM the premium will be a multiple of a vanilla option. The premium of such a Conditional Premium Option is calculated by dividing the premium of a vanilla optionconditional premium option (1.5%, see diagram 5) by the chance it will be exercised (Delta, in this case 25%), ie 1.5% : 25% = 6%. It could be a very disappointing to find that if this Conditional Premium option is only marginally ITM at maturity, because the premium of 6% still has to be paid.

A Conditional Premium Option is constructed by buying a vanilla option and selling a digital option with the same strike. The digital option will be for a payout of 6% and because it also has a chance on exercise of 25% it will generate 1.5% premium, offsetting the premium of the vanilla option.

Next week in the last Option Tales article; the Reverse Knock-Out Option (RKO).

Would you like to read more on Rob Söentken’s Option Tales?:

1. Options are for wimps

2. ATM or OTM

3. Cheap Options part I

4. Cheap Options part II

 

Rob Soentken

 

 

Rob Söentken

Ex-derivates trader

Option Tales: Cheap Options Part II

| 24-05-2016 | Rob Söentken |

bankingToday in Rob Söentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. In the previous article I talked about the first two solutions: Choose the strike further OTM and Choose shorter tenor. Today I will be discussing the next two solutions: Choose the longer tenor and the Compound option.

 

3- Choose longer tenor

Following the comparison between a 3-month and a 12-month option, it should be remembered that a 12-month option will have some remaining value after 3 months have passed, at least theoretically. If we assume ‘ceteris paribus’ (everything remained unchanged) the remaining option value of a 12-month option would be 1.1%. If we diagram1pt2bought the option for 1.5%, we could sell it after 3 months at 1.1% and buy the USD through an outright forward transaction. This approach shows that the net cost of option protection would be only 0.4% (1.5% – 1.1%). Which would be cheaper than the premium of a 3-month option with the same Delta. Also, because the option has a higher Delta than a 3-month option with the same strike (25% vs 10%, see diagram 2), it will follow the spot market much better. The bottom line of paragraph 3 is that a longer dated option can be bought with the intention to sell it again at some point, the net cost being less than buying a shorter dated option. While it serves as a hedge against price changes.

4- Compound option

A compound option is the right to buy an option against a certain premium. For example we could be considering todiagrampt2 buy the 1-year option in diagram 2 for 1.5%. Alternatively we could consider buying a right to buy this option for 0.4% in 3 months time. At that time the 1-year option will only have 9 months remaining, but the strike and 1.5% premium are fixed in the contract. On the expiry date of the compound option we can decide if we want to pay 1.5% for the underlying option. Alternatively, assuming nothing has changed, we could buy a 9 month option in the market for 1.1% (see diagram 2). In such a case we wouldn’t exercise the compound option.

An alternative to the compound option would be to buy the 3-month option for 0.2%. On expiry, assuming nothing has changed again, we could buy a 9 month option in the market for 1.1% (see diagram 2).

In my next two articles I will discuss the last two solutions for minimizing premium expenses when buying options:

  • Conditional Premium option
  • Reverse Knock Out

Would you like to read more in Rob Söentken’s Option Tales?
1. Options are for wimps
2. ATM or OTM
3. Cheap options part 1

 

Rob Soentken

 

 

Rob Söentken

Ex-derivatives trader

 

Option Tales: Cheap Options Part I

17-05-2016 | By Rob Soentken |

banking

 

Today in Rob Soentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. Today I’m discussing the first two solutions: Choose the strike further OTM and Choose shorter tenor.

 

1-Choose Out of The Money (OTM) Strike

Hedging the purchase of a certain amount of USD could be done by purchasing a USD call option with the strike set At The Money (ATM). In diagram 1 it shows that such an option would costs about 2.0%. The strike is 0% OTM, so ATM. A strike further OTM would cost less premium. For example, a strike set at 3% OTM would costs only 0.8%. The cost saving is 1.2%, but also the protection kicks-in only after USD has appreciated by 3%. Should we need to exercise the option to get our USD, it still means a combined hedging cost of 3.8%. Which is more than if we had bought the ATM option for 2% premium. Conclusion: Buying an OTM option reduces the up-front cost versus buying an ATM option. But ex-post hedging with an OTM option could result in total hedging cost which are higher than an ATM option.

2- Choose shorter tenor

Hedging the purchase of a certain amount of USD in 1-year time could be done by purchasing a USD call option with 25% chance of exercise. In diagram 2 it shows that such an option would have a strike 6.2% OTM and would cost 1.5%. Options with the same strike but with a shorter tenor would cost less up front. For example: choosing a 3-month time to expiry would make the option premium 0.2%. It must be noted that while the 3-month option has the same strike as the 12-month, its chance on exercise (Delta) is substantially less. By itself choosing a 3-month tenor is not ‘wrong’ when hedging a 12 months USD flow. It is just the on the expiry date of the option either the option is exercised, or the USD must be purchased from the market at the prevailing rate.

 

 

In my next two articles I will discuss the following solutions for minimizing premium expenses when buying options:

  • Choose longer tenor
  • Average rate option
  • Conditional Premium option
  • Reverse Knock Out

Want to read more in Rob Soentken’s Option Tales?

Option Tales – Options are for Wimps
Options Tales – ATM OR OTM?

 

Rob Soentken

 

 

Rob Soentken

Ex derivates trader

Option Tales: ATM or OTM?

banking10-05-2016 | By Rob Soentken |

 

When uncertainty is substantial and the decision was made to hedge with options, should the strike be put ‘At The Money’ (ATM) or ‘Out of The Money’ (OTM)? Diagram 1 shows the dilemma.

 

 

An ATM call option on USD with strike at 1.1400 costs about 2% while a 4% OTM option with the strike at 1.0944 costs only about 0.6%. The latter is substantially cheaper but the protection only kicks in once the USD has appreciated 4%.

option tales - 1

We know the premiums and the strikes, but each strike / premium combination has its merits. It would help if we would know the amount of Risk we are running. To speak in terms of insurance: We know the premium, but we do not know the potential loss. One thing we do know is the chance on that loss. This chance factor is called Delta. It is the chance of the USD appreciating below the strike of the option. The premium divided by the chance on the loss is the potential loss. It could be more, it could be less, but it is the estimated average loss. For example: The 1.14 strike costs 2% premium and has a 50% chance of being worth anything. Therefore the 2% is the premium on an insurance contract potentially worth 2% : 50% = 4%. Lets call this Risk.

Diagram 2 shows Premiums, Delta and Risk for various OTM strikes.option tales - 2 Risk appears fairly stabile across strikes, which makes sense because the premiums are calculated with one volatility on one underlying. The Risk on OTM is lower than that for ATM options. It appears that OTM premiums are relatively more expensive, they give protection against less potential loss.

Knowing the Risk to be around 3.5-4% on the USD to be purchased, it does not come as a surprise that in real life many option strikes are bought to protect for losses beyond this percentage amount. Hedgers are looking for protection beyond the expected potential loss on the underlying. These are OTM strikes in this case 3-4% OTM, with a Delta (chance of exercise) between 20-25%.

option tales - 3Diagram 3 shows Premiums, Delta and Risk for different tenors. ‘Time’ is the time to expiry of the options in fractions of years. Its shows that for longer tenors, the Risk is higher. But disproportionally. For the same chance on exercise a hedger could double the premium to buy a hedge for a 4x longer tenor.

Rob Soentken

 

 

Rob Soentken

Ex-derivatives trader

 

Options are for wimps

26-04-2016 | by Rob Soentken |

bankingDoes it make sense to use options for hedging? The following little story is about a senior person who I respect a lot, and who didn’t like using options.

One day he asked me to execute some call options for his investment book. He never used options, so I asked him if he had changed his mind about the product. He just laughed and said he hadn’t.

“Why would I buy an option if I know the prices are going up? Any option premium I pay is lost money.” 

Somehow I’m convinced he held the same opinion about selling options.

Value of a USD and Call option on a USD

Options are for wimps - diagram 1Diagram 1 explains his feelings. I assume he was considering only the left half of the payoff diagram. After an appreciation of the USD, a USD is always worth more than a call option on a USD, the difference being the option premium.

There is no downside if you ‘know’ where the market is going, if there is no uncertainty. Using options implies you are not sure about the direction. In a way he was saying ‘options are for wimps’.

The future of the USD is leading

For a company importing goods from outside the EUR zone the choice could be very similar: to buy the foreign currency outright or buy a call option on that currency. Possible actions are driven by the views on 2 dimensions of the USD future:

  1. Where will USD go? Down or Up?Where will USD go?
  2. How will USD go there? Steadily or Uncertainly?

These 2 dimensions lead to 4 possible actions for hedging currency risk, as depicted in Diagram 2.

If the view on USD is Up, in a Steadily way the choice to ‘buy USD or buy an option’ is straightforward: Buy 100% of the required USD, because any option premium would be wasted money.

If the view on USD is Up but in an Uncertain manner, it could be recommendable to buy 100% At-The-Money options. Obviously the premium is an expense, but considering the expected Uncertain price action the price of USD could also be going down, meaning the USD can be purchased against cheaper than expected prices. This would represent a gain possibly offsetting and exceeding the loss of the premium.

If the view on USD is Down and in an Uncertain manner, it could be recommendable to buy 100% Out-Of-The-Money options. Like my manager in the beginning of this article, this call would be a back-stop against unexpected outcomes. Obviously the premium is an expense, but considering the strike being Out-Of-The-Money, it’s a relatively small one.

Finally, if the view on the USD is Down, and in a Steadily way it could be an interesting approach to hedge a certain percentage and to add to that position in a dynamic way, until the full 100% of the required USD amount has been purchased. In a way this position is a replication of buying a Call option, without incurring the expense of the premium. Obviously there could and would be cost involved if additional USD purchases would be above the initial purchase. But if the Down view materialises, there would be gains in the form of cheaper USD purchases.

Above article reflects the personal views of the writer. It should not be used as a guidance to the use of derivatives in the context of investments or risk management. Any investor or risk manager should develop and determine their own independent views and actions.

Rob Soentken

 

Rob Söentken

Ex-derivatives trader