One of the difficulties companies face when using path dependent options, such as leveraged collars or participating forwards, is that the amount of cover in place will alter under different market conditions.
Example:
- NZ based exporter hedging USD receipts to NZD
- FX product = leveraged collar
- Leverage ratio = 2 for 1
- Protection amount = US$1 million
- Participation amount = US$2 million
- Expiry = three months
- Protection rate = 0.7200
- Participation rate = 0.6500
Outcomes
The spot rate at the expiry date of the leveraged collar will impact the amount of cover:
- if the spot rate is less favourable than the protection rate (i.e. higher than 0.7200 in this example) the hedged amount will be US$1 million at the protection rate.
- if the spot rate is more favourable than the participation rate (i.e. lower than 0.6500 in this example) the hedged amount will be US$2 million at the participation rate.
- If the spot rate is in between the protection and participation rates there is no obligation to transact
Therefore, depending on where the spot rate is at expiry, the exporter could end up with US$1 million at 0.7200 or $2 million at 0.6700 (or zero if in between the protection and participation rates). The primary reason for entering this type of hedging instrument is to improve the protection and/or participation rate than could otherwise be achieved without leverage.
Risk Management
From a risk management perspective, the company hedging their foreign currency cashflows needs to understand the impact alternative scenarios can have on hedging cover, both amount and rate. Often there are policy limits to adhere to, so having visibility over these, and ensuring limits are not broken, is important.
Hedgebook Reports
The FX Exposure Report in Hedgebook gives the user visibility over their hedge position under alternative outcomes. Hedging percentages, weighted average hedged rates and policy compliance under the best and worst case scenarios can easily be compared. The Currency Impact Report shows the potential dollar impact on the bottom-line under a number of alternative exchange rate scenarios. Both are available from the FX Reports drop-down menu in Hedgebook. Some of the output from these reports is shown below.
Hedgebook gives users of structured options greater confidence that these complex instruments are being recorded, valued and reported appropriately.
If you are an existing user and want some training, or you are interested in a demo of the Hedgebook software, contact us here: https://www.hedgebookpro.com/contact/.