Exposure to the interest rate markets can be hedged with many financial instruments. One of the more flexible is the risk reversal. A key benefit of the risk reversal is that it does not exposure the hedger to immediate gains or losses (similar to a swap or futures contract) as it allows the hedger to create a range in which their exposure is un-hedged.
Futures Contracts A futures contract is an obligation between two parties to purchase or sell a physical or financial product as some date in the future. Interest rate futures are traded on exchanges such as the Chicago Mercantile Exchange and provide a clearing platform for traders that eliminate credit risk.
Hedging The strategy of a risk reversal for a hedger that is looking to mitigate downside exposure to the interest rate market is to purchase a put on an interest rate futures contract and simultaneously sell a call on an interest rate futures contract. The strike price of the call and the put are generally a certain percentage away from the current spot price, creating a range above and below the current price where the trader is not hedged. If the price of the futures contract falls below the put, the trader receives a payout. If the price of the futures contract rises above the call, the trader needs to make a payment.
One of the most interesting strategies that can be used by investors or treasurers to hedge their exposures to the currency markets is a risk reversal. This type of option structure will hedge a currency pair by protecting against the downside with a put option and financing the put purchase with the sale of a call option. If a business wanted to hedge an upside directional move in a currency pair they would structure a risk reversal in which they purchased a call and sold a put option.
Call Option Basics A currency pair call is the right (but not the obligation) to purchase a currency pair at a specific strike, on or before a certain date. The exchange rate that the parties that transact a currency call is referred to as the strike price, while the date when the option expires is called the expiration date. The strike prices for the currency call and currency put generally straddle the market price.
The Payout of a Risk Reversal
A business that is protecting against a downward adverse move in a currency pair can use a risk reversal by selling a call and purchasing a put with strike prices that are above and below the market price respectively. Some attempt to offset the entire cost of the put with a call making the structure a zero cost risk reversal.
If the currency pair at expiration is below the put, the business will receive the difference between the strike price and the price at expiration multiplied by the volume of currency describe in the put option. If the price of the currency pair is above the call, the business will need to pay away the difference between the strike price and the market price at expiration multiplied by the volume described in the option contract.
Currency hedging is a financial exercise in which a treasurer will mitigate their exposure to directional currency movements in an effort to smooth returns or stabilize cash flows. One of the easiest and most effective ways to hedge a currency position is to purchase a protective put, which will offset any losses below a specific strike price.
Put Option Basics A currency pair put, is the right but not the obligation to sell a designated currency pair at a specific strike, on or before a certain date. The exchange rate that the parties that transact a currency put is referred to as the strike price, while the date when the option expires is called the expiration date. European style currency options allow the owner of a put to exercise the put only on the expiration date while American style options allow the flexibility to exercise the option on or before the expiration date.
The Payout of a Currency Put The payout a currency hedger receives from the purchase of a put is the difference between the spot market of a currency and the strike price of the option at the time the option is exercised. Options can be settled on a physical basis, where actual currency changes hands at the strike price exchange rate or on a cash basis where one party makes a payment to its counterparty.