Ane Lottering

Ané Lottering

Ané Lottering

Forex Options Trader

Derivatives Demystified - Collar or Risk Reversal

Hi, and welcome to my latest installment of "Derivatives Demystified."

USDZAR traded through 17.00 this week as the USD continues to strengthen! I imagine traders around the globe drumming on their desks and singing barbarian war songs.

I think it's a good time to write about an FX options structure called a "collar" by clients or a "risk reversal" by volatility traders.

Let's start with the client's stance.

Example: Client hedges offshore exposure
A client invested USD20,000,000 in offshore assets when USDZAR was trading at 16.00. At the start of their investment, they had to sell ZAR320,000,000* to buy USD20,000,000 to purchase offshore assets.

For this example, the offshore assets price has not changed, and they are still worth USD20,000,000. So with USDZAR trading at 17.00, the assets translated value is ZAR340,000,000**, or the client is recording a "translation profit" of ZAR20,000,000***.

*20,000,000 x 16.00
**20,000,000 x 17.00
***ZAR340,000,000 - ZAR320,000,000

The client profits when USDZAR trades higher, and they incur losses when USDZAR trades lower.

The client could hedge this risk by simultaneously buying a USD put and selling a USD call. This strategy is called a collar.

The client decides to hedge their exchange rate risk for one year because that is when they want to sell their offshore asset. So they buy a 17.00 strike USD put in USD20,000,000, and they sell an 18.3600 USD call in USD20,000,000. This structure has zero upfront premium.

Worst Outcome: If USDZAR trades below 17.00 at the end of one year, the client will exercise the USD put or their right to sell at the strike. The client sells USD20,000,000 at 17.00 and receives ZAR340,000,000.

Participation Outcome: If USDZAR trades between 17.00 and 18.3600 at the end of one year, neither the put nor call will be exercised, and the client is free to sell USD20,000,000 at the market rate. If the market rate is 17.9500, the client can receive ZAR359,000,000.

Best Outcome: If USDZAR trades above 18.3600 at the end of one year, Investec will exercise the USD call or their right to buy at the strike. The client will have an obligation to sell at the strike. The client sells USD20,000,000 at 18.3600 and receives ZAR367,200,000.

Why would a volatility trader like me make a price to the client and trade this? The first hint is that I call it a "risk reversal" and not a "collar."

I have to take you back to The Wolf of Wallstreet scene where an immaculately suited and a bietjie thin stockbroker Mark Hanna explains to then-green Jordan Belfore his number one rule of Wallstreet. Later in this scene, they start gorilla-banging their chests, but this has no relevance. "Nobody knows if a stock is going to go up, down, sideways, or in circles... It's all a fugayzi; it's a whazy, it's a woozy, it's fairy dust."

You'll remember in my installment on "Delta," I wrote that volatility traders hedge their delta, making them immune to whether USDZAR spot/forward trades higher or lower or sideways. Our positions are, however, exposed to volatility.

In our example, I sold a USD put and bought a USD call from the client. So I effectively sold volatility by selling the USD put and bought volatility by buying the USD call.

We have noticed that if USDZAR blows out, volatility increases, and if USDZAR slowly trades lower, volatility decreases.

That is how I'm positioned if I enter this structure. If USDZAR blows out, I become long volatility and can potentially profit. And if USDZAR trades lower, I become short volatility and can potentially benefit. Since I can either be long or short volatility, or my risk can reverse, I call this structure a risk reversal.

Like Hanna, I can flutter my fingers like I'm sprinkling powder on the city skyline, but unlike Hanna, I don't believe it's all fairy dust. Instead, there is structure and good opportunities for clients and bankers with a good knowledge of derivatives.

Thanks again for reading! Next week I will demystify trading volatility and "vega" if you want to keep an eye out.