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I build businesses, both as independent startups and as new initiatives within large global companies. This series of posts is based on an FX Options training course that I delivered whilst contributing to building FX businesses at a number of investment banks. If you are looking to build a business and require leadership then please contact me via the About section of this website.
In this section we will take another practical look at how a salesperson in an investment bank might go about pricing a popular client hedging strategy, the trigger forward. To get the most out of this section you should have covered the most relevant earlier sections, including options valuation, how to execute an FX option and reverse knockin options.
The trigger forward is one of the most popular strategies used by clients who are seeking to hedge transactional exposures. It is a very effective structure as it always provides protection against downside movements in an exposure whilst leaving opened the potential to benefit from any favourable movements in spot.
The trigger forward is as the name suggests a synthetic in forward position that is constructed as using two options. Firstly, the client buys a European standard option. The purchase of the European standard option is then financed the by the sale in of a reverse knockin option. This strategy is typically traded with a client for a net zero premium.
The European standard option that the client buys has the same strike price as the reverse knockin option that that the client sells. The key to the structure therefore is to select an appropriate strike for the two options such that the instrike of the reverse knockin is sufficiently far away from spot to give the client the upside potential.
The following guide takes you through a step-by-step process for building the structure.
This strategy involves buying one option from the client whilst simultaneously selling the client a different type of option with the same strike price. For example, if the client has an underlying short exposure an appropriate hedge would be to buy a call option to protect against any losses as spot moves higher. In the trigger forward strategy the option that the client buys is a European standard option, which in the above case would be a call option. In the above case the purchase of the European standard call option is funded by the sale of a reverse knockin put option which has an instrike set at a lower rate than the strike price.
Given that a reverse knockin option is cheaper than the equivalent standard option then it is clear that in choosing the strike the of the European standard option it must be at a less favourable rate than that of the market rate in the outright forward market to the same delivery date as the option structure. We can see that this must be true because the trigger forward has an upside potential that would be lost with a standard cash forward. Therefore, to avoid arbitrage the trigger forward structure must have a worse implied forward rate than the outright forward rate in the cash market.
So step one is to observe the outright forward rate in the market for the same delivery date as that of the strategy. This rate can be seen on the FENICS pricing page in the markets input section under forward.
Step two is to choose a strike price for the European standard option. If the European standard option is to be a call option (i.e. an option that gives the right to buy the underlying at expiration) then in order to have a strike price that is less favourable than the outright foreword rate, then the strike price must be HIGHER than the forward rate. Conversely, if the European standard option is a put option then the strike price should be set to a LOWER rate than the outright forward rate in the market.
Price the European standard option and note down the premium that the client will be required to pay.
Now price a reverse knockin option such that is the opposite class of option to the European standard option. For example, if the European option is a call option than the reverse knockin option should be a put option. At this stage you should set the barrier at a level that you believe would be attractive to the client.
We now need to solve for the barrier of the reverse knockin option such that the strategy can be dealt for a net premium of zero.
The barrier that you select should be such that the amount of premium that we will receive from the client for the sale of the European standard option is matched by the amount of premium will pay the client for buying the reverse knockin option from them. So, having previously noted the amount of premium that we will be receiving for the European standard option we must now vary the barrier of the reverse knockin option until the bid of that option equals the required amount of premium.
If you are unable to find a barrier that pays sufficient premium to cover the cost of the European standard option then you'll need to adjust the strike prices of the two options to a less favourable synthetic forward rate i.e. you need to make the option that you are selling to the client cheaper.
Similarly, if the barrier that you solved for is too close to spot and therefore is unattractive to the client then it will be necessary to adjust the strike prices of the two options to have a less favourable synthetic forward rate.
If you want to build in additional profit margin to the trade then the amount that you would receive from the client for the sale of the European standard option must exceed the amount that you pay the client for the reverse knockin option by the amount of additional profit margin you wish to take. However, we have already noted that this option structure is traded with the client for net zero premium and therefore the amount paid must equal the amount of premium received.
To build in additional profit margin you should solve for the reverse knockin barrier such that you are due to pay the client an amount equal to the required additional profit margin. When the trade it is confirmed with the client for zero premium the net amount due to be paid to the client is retained as additional riskless profit margin.