Global regulatory changes are making options more appealing than forwards and swaps for hedging. IFRS 9 accounting standards and Basel III regulations increase the costs of swaps and forwards for banks and corporations. Options will have relatively lower credit charges. As a result, corporations may consider alternative hedging strategies like target redemption forwards to address these regulatory changes while still minimizing risks. Target redemption forwards offer corporations attractive protection rates through leveraged forwards overlaid with a target level of cumulative profit. This structure provides downside protection and upside participation if currency moves are favorable. However, the uncertain maturity is a drawback as the hedge may be redeemed before needed.

1. Looking at the global regulatory
outlook, there are also changes that
could potentially make options
more appealing as a hedging tool
than vanilla forwards and swaps. For
example, the new hedge accoun-ting
standard under IFRS 9 includes
favourable changes to how options
are accounted for, specifically no
longer requiring time value to be
excluded for earnings under certain
circumstances. In addition, Basel III is
expected to force an increase in credit
charges for banks on derivatives
transactions, which will ultimately be
passed on to the corporate end user.
To avoid an unnecessary increase in
the cost of hedging, options may be
looked to as an alternative as the cre-dit
charge will be much less relative
to forwards and swaps.
In lieu of all this, corporations may
look to consider different trade ideas
that will allow them to address re-gulatory
changes while also minimi-sing
their risk in the same way they
normally would.
TRADE IDEA: target redemption
forward
Let’s take an example of a UK com-pany
with USD exposure. Looking at
the chart of the ten-year performance
of EUR/USD, it would appear the pair
CORPORATE FINANCE
has been on a slow but steady ranging
downward trend since the peaks seen
at the start of the financial crisis back
in 2008. If this trend is anything to go
by, then we appear to currently stand
in the middle of one of the rallying
periods, knowing that at some point
in time the euro might start heading
down.
For the euro exporter to the States
looking to protect themselves against
potential falls in their home currency,
the question is whether to bank on a
continuation of the current upward
trend and enter into a structure that
has the freedom to benefit from this,
such as a risk reversal or forward ex-tra,
or take on a position which offers
instant outperformance should the
euro in fact return to its downward
path.
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For those standing in the latter camp,
the increasingly popular target re-demption
structure may prove very
attractive. To illustrate why, consider
the case of a euro exporter looking to
sell a constant amount of USD (and
therefore buy euro) every month for a
12-month period. Given the relatively
flat EUR/USD forward curve, it can
be assumed that the current spot and
forward rate over the next twelve
months are the same (for reference
here 1.33 is used) and that this is also
therefore the budget rate.
In a typical target redemption
forward, the trader enters into a strip
of leveraged forwards (usually with
1 x 2 leverage), over which they then
overlay a target, expressed in big
figures, which measures the cumu-lative
profit attached to any and all
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A new era in FX risk management
Corporate hedging strategies have gone through a paradigm shift in recent years. Pre-global
financial crisis, there was a predilection for complex hedging strategies and use of non-linear
derivatives. Post-crisis on the other hand, corporations and financial institutions moved
towards simpler “plain vanilla” hedging derivatives. However, in recent months, as volatility
has declined and risk appetite at corporations has started to grow, the use of non-linear
instruments is increasing, especially short volatility and/or leveraged hedging instruments.
LE MAGAZINE DU TRESORIER / TREASURER MAGAZINE — N°81 — MAR / APR / MAI 2013

2. expiries which finish in the
money. If and when the
cumulative profit reaches
this target the structure is
terminated. The dual risk
taken on by the holder,
i.e. the leverage and the
fact that the structure only
counts positive payouts
towards the target, allows
for the provision of a very
attractive protection rate.
In the simplest case, the
trader places a target of 50
big figures (USD 0.50 per
euro of notional) and the
resultant structure offers
a forward rate of 1.3750 or
450 pips above the ave-rage
forward rate for the
year. This means, for every
fixing below 1.375, 10m
Euro are sold at 1.3750 and
20m if fixed above 1.3750.
If the euro were to sharply
fall to 1.2750, the trader
would still benefit from
five months of the supe-rior
protection rate before
reaching the target of 50
big figures (accumulating
10 big figures of profit per
month compared to spot
for five months). In the
worst case, if the euro
continues to strengthen
and the target is therefore
never reached, they are
committed to sell 20m
euros per month at 1.3750,
something many might be
quite happy to do given the
budget rate of USD 1.33.
Note that if the euro were
to stay constant at 1.33,
they would accumulate
USD 0.045 of profit per
month and only reach the
target in the last period,
i.e. the structure would last
the entire twelve-month
period.
If the trader wanted to get
a bit more creative, they
can vary the structure’s
forward rate so that it starts
deeply in the money and
then tapers off. More pre-cisely,
in the first period,
they are committed to sell
10m euro at 1.43 (or 20m
in the unlikely event they
fix above 1.43) and from
then on, the structure’s
forward rate drops by one
big figure per month i.e.
1.41, 1.40, 1.39 etc until, in
the last two months, they
bottom out at 1.33. In this
case, if the euro were to
stay constant, they would
reach their target of 50 big
figures at the eighth expiry,
having sold 10m euros each
month at an extremely
attractive average rate of
USD 1.3950 (the average of
the rates from 1.43 to 1.36).
In the worst case, even if
they don’t reach the target,
they never sell below the
current spot and forward
rate of USD 1.33 (and for
ten of the twelve months
sell for more).
It seems like a win-win si-tuation,
and in many ways
it is. So where’s the only
catch? The main drawback
of this type of structure is
the uncertainty attached
to the exact length of its
maturity. A company may
end up with very attractive
protection but only for a
short period, and further-more
it will be redeemed
early when they need the
protection most. The other
potential issue to be aware
of is the negative mark-to-market
associated with ex-treme
moves in the market
upwards, which result in
the short leg being activa-ted.
Nevertheless, used as
part of a portfolio of hedges
and in the knowledge that
the most likely scenario is
that the structure redeems
sometimes before its
final end date, the target
redemption forward can
prove an extremely attrac-tive
addition to a hedger’s
toolbox.
Jonathan Binke,
Head of FX Solutions
and
Darren Zuckerman,
Director of Corporate Sales