FX Option Performance. Peter Billington

the expiry date. This will lose money when the rate at expiry is less than the forward, and make money when the rate is higher. The forward rate is costless to lock in other than bid-offer costs.

      The essential thing to grasp about the payoff to an option contract is that it is asymmetric. There is limited loss (the owner of the option can only lose the premium) but in theory unlimited gain. Conversely, the seller of the option stands to make a limited gain but an unlimited loss. Thus the option payoff looks very much like that of an insurance contract: we expect to pay a fixed premium to cover a variety of different loss types, up to and including very large losses indeed.

      The difference between FX options and the more familiar types of insurance such as for a house or car is that, with the latter, we are pretty sure that we are paying more than we really need to. After all, in addition to covering losses, the insurance companies are paying their staff salaries, taxes and business costs. With FX options, we would anticipate that the bid-offer costs or trading activity cover the desk and business costs as a market-making desk makes money from buying and selling options, unlike an insurance company, which can only sell. We would expect the premium to add relatively little to the costs of the option; that the average cost of an option is close to the average payoff for the same option. If it is not (and in many cases we can show that it is not, at least on a historical basis) then there will be a number of interested parties. See the Appendix for more detail on what an option ‘should’ cost.

      1.4 MARKET PARTICIPANTS

      This information has potential to be of use to a wide variety of market participants. One way of looking at it would be to think of option suppliers (sellers of risk) and option consumers (buyers of risk). The former might be balance sheet holders who can sell a ‘covered option’ – essentially, if they hold the underlying currency, they can make money by selling an option which pays out if the currency rises but not if it falls. If it rises, their holdings will increase in value so they can pay the option holder. If it falls, they do not have to pay but they collect the premium. The option consumers have unwanted currency risk they need to reduce, like an investor with an international portfolio of bonds, or a corporation selling goods in another country. Additional to option suppliers, there are market makers like the option desks of larger banks, which both buy and sell options to make a profit from the bid-offer spread. Also there are purely profit-focused entities, like hedge funds, which take views on direction or inefficiencies in the market to make money. Finally the world's central banks can direct massive FX flow, sometimes using options, to execute policy aims like currency strength or weakness. And each of these has properties of the others; a portfolio manager may wish to protect against currency risk but derive some return, and even a central bank may maintain a trading arm to smooth volatility and influence currency levels.

      The accounting and regulatory bodies additionally maintain a strong interest in the use of FX options, and could be interested to learn that in some circumstances simple options can be more useful than forward contracts. Thus a wide range of market participants from central banks to hedge funds, investment banks to insurance companies, corporations to pension funds could find much of interest in the data we present.

      Perhaps the most useful division of FX option traders is into two broad categories: those who wish to protect against losses due to foreign exchange movements, and those who wish to make money from those same movements. We can call them the hedgers and the investors, while understanding that most trading entities contain both types to some extent.

      1.4.1 How Hedgers Can Use This Information

      A good example of a hedger would be a European corporate which sells cars to the United States (US). Assuming they have no manufacturing capacity in the US, then their expenses are largely in EUR while a large part of their income will be in USD.9 If the value of the USD falls relative to that of the EUR, their income will drop but their expenses will remain fixed. Thus they would possibly like to insure themselves against this eventuality.

      Such insurance will naturally be temporary in nature; one could insure for a period, but eventually it will expire and the company will be left with the new exchange rate to deal with. But what can be covered are sudden price jumps over the period, so that at the end of the year (if the period is a year) the company can take stock and plan the following year with some confidence.

      So it will be useful to be able to protect against sudden damaging drops in the value of the USD. But it would be good for the company if sudden rises in the value of the USD, which would be beneficial, could nevertheless be taken advantage of. These two facts are important to the company's decision of whether to hedge the risk.

      Clearly an option, with its asymmetric payoff, will be of interest in this situation. If the company could be reasonably confident that the option offered good value for money, then it would be the obvious choice. However, in general, the company will simply not know whether the option is good value. It is often assumed that because options are more complex than forward hedges they must be much more expensive. So if we can show that under some circumstances options have historically not been expensive, the corporates which currently avoid them would be interested to take another look.

      Of course payoff is not the only factor to consider when choosing a hedge strategy. A forward hedge will reduce overall volatility, as it is in some ways simply the opposite exposure to the hedged quantity. So if this is important, the forward rate will have an advantage.

      Additionally, for a hedger the evolution of the underlying is critical. Many corporate hedgers already effectively have an FX position – our European car manufacturer mentioned above might buy a protective option and never need it, with the money spent on the premium being lost. But, if the USD has appreciated several percent in the period, they will have made money overall. Conversely, a sophisticated hedge programme might sell a few short dated call options on the EURUSD rate, reasoning that if it moves in their favour (decreasing rate in this example) then they will make money and can cover the option payoffs. Their reasoning may be that if the rate moves mildly against them then they will pick up some mitigating profit from the option premiums – but this will not help them much if the rate move is large.

      Finally, accounting and tax treatments will play significant roles in the choice of hedge strategy and tend to favour forward contracts. Perhaps if the historical behaviour of options were more widely known it might have an effect in these very different circles.

      1.4.2 How Investors Can Use This Information

      The word ‘investors’ covers a wide variety of market participants; we list a few below:

      • Insurance companies

      • Hedge funds

      • Pension funds

      • Mutual funds

      • High Net Worth individuals.

      The investors will want to make money. They are motivated to use money to make more of it. Thus they will buy an option if they have reason to believe that the payoff will be larger than the premium, and sell it if the opposite is the case.

Short10 dated option selling uses the fact that, in some markets, the investor believes that the premium is too large given the risks in the market (more of this later…). A truly classic example of this would be in the aftermath of a high risk period. Shortly after the market shock caused by the Lehman bankruptcy in the autumn of 2008, FX option volatilities remained very high for some months. They were implying that markets in the future would be choppy and very active. Essentially, they were reflecting the views of nervous and shaken market participants that the market was in a state of high risk. In fact, the months following the 2008 crisis were consistently less volatile than implied by the option volatilities; selling options would have been very profitable. In Figure 1.2 we show the cumulative result of selling one-week EURCHF options each week between 1998–2013. We chose EURCHF as an example here to include a currency pair which had periods of very low and very high volatility. It is easily seen that the investor who correctly judged when the market was overestimating the future risks would have made strong returns – but it would have taken nerves of steel. A misjudgement could have seen sharp losses,

9

When referring to currencies we will use the three-letter ISO codes, so EUR for the euro and USD for the US dollar. A table is given in the Appendix.

10

Short dated contracts in FX usually refer to anything up to 3M tenor. Long dated would be 1–5 years.