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Welcome to Exotic Options Over the last couple of years options have become an important tool for investors and hedgers in the foreign exchange market. With the growing sophistication of market participants new ways of expressing views on the market or reducing hedging costs have evolved in the form of Exotic Options. Today a large variety of these products is available to the user. One of the reasons for the success of such second generation derivatives is their flexibility. They are unique in the sense that they allow the user to express his/her views in almost unlimited ways and structure products which specifically fit his/her needs. Today a large variety of these products is available to the user. To fully extract the utility of these instruments it is vital for the user to understand the products and the way they behave. The purpose of this brochure is to provide the reader with a description of the most popular instruments and a brief discussion of the specific utility they provide. Due to the different needs and preferences of hedgers and investors this brochure is divided into two sections which focus on each group separately.
Table of Contents Hedger Knock Out Option 6 Step Payment Option 7 Kick Into Forward 8 Range Reset Forward 9 Kick In Option 10 Investor Knock Out Option 12 Kick Out Option 13 Double Knock Out Option 14 Kick In Option 15 Parity Out Option 16 Knock Out Forward 17 Double Lock Out Option 18 One Touch Option 19 Digital Option 20
Hedger Corporate treasurers are not only confronted with uncertain political and macroeconomic developments but also an ongoing trend of business globalisation, making currency risk management increasingly difficult and challenging. In addition hedgers have to address shareholder concerns with increased professionalism and more sophisticated hedging techniques. In light of these developments, Exotic Options are starting to play a vital role as hedging instruments that specifically meet treasurers needs in cost effective ways. In order to reduce hedging costs treasurers can move away from buying general protection and instead start tailoring their hedging strategies to the specific exposure the company faces. By excluding unneeded elements of an insurance the upfront cost of a hedging strategy can generally be reduced. In light of these developments, Exotic Options are starting to play a vital role as hedging instruments that specifically meet treasurers needs in cost effective ways. strategies. However, treasurers have to be cautious of the amount of risk they accumulate in their hedging strategies, because, as with every other financial instrument, a reduction in hedging costs while maintaining the same level of protection can only be achieved through accepting some other form of risk. It is important that the user is aware of this risk/ return trade off and that he/she has to achieve a balance between the risk and return of a strategy versus its suitability. On the following pages you will find some examples of hedging strategies which we believe bear an appropriate amount of risk for hedging purposes. Yet another way of optimising hedging costs is to embed market views. Nowadays treasurers commit a considerable amount of time assessing market conditions and should therefore capitalise on this by reflecting their market expectations in hedging
Knock Out Option Hedger Purchase a protective option against your underlying exposure. In addition to the strike, this option has an outstrike which is set in the out-of-the-money direction. If spot reaches the outstrike before maturity, the protective option is terminated, but spot is at a favourable level with respect to your underlying exposure. In exchange for this possible give-up, the Knock Out Option premium is lower than the equivalent standard option premium. Market Data USD/CHF 1.4500 Forward 0.0550 Outright 1.3950 Data Expiry 1 year USD call/chf put Strike 1.4000 Outstrike 1.3700 Premium 420 CHF pips 0.20 0.15 0.10 0.05 0.00 0.05 0.10 Outstrike 1.3700 1.20 1.30 1.40 1.50 1.60 of Knock Out Option of standard option Assuming you need to hedge a one year short USD/CHF exposure, you could achieve this using a Knock Out USD call option with strike of 1.4000 and outstrike of 1.3700. The strategy gives you the right but not the obligation to buy USD against CHF at 1.4000, if spot never reaches the outstrike at 1.3700 during the life of the option. Should spot reach 1.3700 before expiration then the Knock Out Option is automatically terminated. At this point, however, spot has moved favourably with respect to your underlying exposure. Due to the possibility that the Knock Out Option is terminated before maturity, its upfront premium is only 420 CHF pips, as opposed to the upfront premium of 590 CHF pips of the standard equivalent. The option is considered knocked out if spot ever trades at or beyond the outstrike during the life of the strategy. Reduced Hedging Cost Hedge exists when needed If the Knock Out Option finishes in-the-money without having reached the outstrike, it protects your underlying exposure from unfavourable spot movement. In this case, you are clearly better off than if you had purchased the standard option, because the premium of the Knock Out Option was lower. The Knock Out Option only ceases to exist when spot has moved in favour of the underlying exposure, giving you the opportunity to close your underlying position at a more favourable rate or reassess market conditions. Hedging your underlying exposure with a Knock Out Option allows to reduce your upfront hedging costs. Due to the lower upfront premium you are better off owning the Knock Out Option instead of the standard equivalent if spot either finishes in-the-money without having touched the outstrike beforehand, or if spot finishes out-of-the-money. Should spot however reach the outstrike, retrace and finish in-the-money, you may have been better off with the standard option. In the event of a barrier transaction it is therefore advisable that the hedger takes action in the form of a spot, forward or option transaction to avoid being unhedged for the remainder of the hedge horizon. For hedgers who do not want the outstrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 6
Step Payment Option Hedger The Step Payment Option is a standard option where some or all of the premium is deferred and contingent upon spot reaching certain prespecified triggers during the life of the option. If spot does not touch these levels, the buyer has to pay no premium. If all trigger levels are touched, the maximum possible premium paid will be higher than the upfront premium for the equivalent standard option. Generally the Step Payment Option is structured for zero upfront premium. Market Data USD/CHF 1.4500 Forward 0.0550 Outright 1.3950 Data Expiry 1 year USD call/chf put Strike 1.4000 Triggers 1.4000, 1.3500, 1.3000 Premium zero upfront premium 0.20 0.15 0.10 0.05 0.00 0.05 0.10 break even position resets at this point to a new level 1.25 1.30 1.35 1.40 1.45 1.50 1.55 no triggers touched 1.40 trigger touched 1.35 trigger touched 1.30 trigger touched standard option Assuming you need to hedge a one year short USD/CHF exposure, you could achieve this using a Step Payment USD call option with strike 1.4000 and 3 trigger levels at 1.4000, 1.3500 and 1.3000. This strategy gives you the right but not the obligation to buy USD against CHF at 1.4000. You pay no upfront premium for this hedge, but for each of the trigger levels that is touched you have to pay.0300 CHF per USD, which means that worst case (with all 3 triggers touched) you will pay.0900 CHF per USD. The standard option, for comparison, would cost you.0600 CHF per USD (therefore as long as spot does not touch more than 2 levels this hedge is cheaper or equal than the standard option). If the USD moves lower you can buy your USD at a more favourable rate but you have to pay the premium installments. To the USD upside you are completely hedged. Participating Hedge Premium Contingency The Step Payment Option behaves, with the exception of the premium contingency, like a standard option and therefore gives the hedger the opportunity to participate in a favourable movement of spot with respect to the underlying exposure, while remaining hedged at all times. As opposed to a standard option, where the premium amount has to be paid upfront in any case, the Step Payment Option introduces the element of premium contingency. This means that the premium payment is only due if spot reaches a certain level. The Step Payment Option can be structured to provide the hedger with zero cost protection, if the view he embeds into the strategy proves to be correct. As soon as spot reaches a trigger level, part of the maximum possible premium outlay is due. The maximum possible premium payment the hedger can potentially incur is always higher than the upfront premium of the standard option, due to the possibility of no premium outlay at all. Should a Step Payment Option Hedge not appear to be attractive due to low implied volatilities or illiquidity of the underlying currency pair, the step payments can be chosen to depend on the movement of a different currency pair for optimisation purposes (Dual Currency Step Payment Option). 7
Kick Into Forward Hedger Market Data USD/DEM 1.8000 Forward 0.0200 Outright 1.7800 Data Expiry 6 months Strike 1.7650 Instrike 1.9000 Premium zero upfront premium Enter into an agreement to protect your underlying currency exposure which, unlike a forward outright hedge, allows you to participate up to a certain extent in a favourable movement of spot with respect to your underlying position. This opportunity comes at the cost of a worst case hedge rate, which is slightly less favourable than the ordinary market forward outright. The Kick Into Forward is a standard option that converts into a forward contract if spot trades at or beyond a predetermined instrike. The resultant forward contract obligates the seller and buyer to exchange currencies at the strike price of the original option on the settlement date. Generally the Kick Into Forward is structured for zero upfront premium. 0.20 0.15 0.10 0.05 0 0.05 0.10 0.15 Instrike if spot hits this level, the option turns into the forward at 1.7650 1.60 1.65 1.70 1.75 1.80 1.85 1.90 Before Trigger Transaction After Trigger Transaction Market Forward Assuming you need to hedge a six months long USD/DEM exposure, you could achieve this using a Kick Into Forward with strike 1.7650 and instrike 1.9000. This strategy gives you the right but not the obligation to sell USD against DEM at 1.7650, as long as spot does not reach 1.9000 during the life of the strategy. Should spot however touch the 1.9000 level, then your right to sell at 1.7650 will become an obligation to sell, leaving you 0.0150 DEM per USD worse off than the market forward rate on the day that the trade was initiated. Participating Hedge Alternative to Risk Reversal The Kick Into Forward allows the hedger to participate up to a certain level in a favourable movement of spot with respect to his underlying position while remaining hedged at all times. The Kick Into Forward is an attractive alternative to using a risk reversal (range forward) to hedge an underlying position in that it displays different break even features. With a risk reversal your participation in a favourable spot movement is capped at the strike of the option sold to finance the premium, whereas with the Kick Into Forward you participate up to the instrike, which is generally far in-the-money compared to the strike you are short in the equivalent risk reversal. The Kick Into Forward is a hybrid between a standard option and a regular forward in that it behaves like a standard option if spot never reaches the instrike. Up to the instrike, the holder therefore enjoys all the benefits of holding an option hedge, but without having to pay any upfront premium. Should spot move in the hedgers favour without reaching the instrike, he is hedged at a better rate than the market forward. As soon as spot has reached the instrike this product behaves like a forward trade: you give up the profit potential if the exchange rate moves in favour of your underlying position. The holder of this forward must exchange currencies at the given strike with the counterparty at expiration. If you find the idea of the Kick Into Forward Hedge attractive, but would like to diversify the risk of barrier transactions to more than one level in exchange for a lower leverage, this can be achieved with the Step Kick Into Forward. 8
Range Reset Forward Hedger Enter into a Range Reset Forward to hedge your underlying exposure at a more favourable rate compared to the current forward outright as long as spot remains within a prespecified range. If spot ever trades outside this range, the forward level resets to a level slightly less favourable than the starting forward outright rate. Generally the Range Reset Forward is structured for zero upfront premium. Market Data USD/DEM 1.8000 Forward 0.0200 Outright 1.7800 Data Expiry 6 months Forward rate 1.8500 Reset rate 1.7700 Range 1.7100 1.8900 Premium zero upfront premium 0.40 0.30 0.20 0.10 0.00 0.10 0.20 0.30 Hedge rate resets from 1.8500 to 1.7700 if the 1.7100 1.8900 range is broken 1.50 1.60 1.70 1.80 1.90 2.00 2.10 RRF Range intact Market Forward RRF Range broken Assuming you need to hedge a six months long USD/DEM exposure, you could achieve this using a Range Reset Forward with forward rate 1.8500, reset forward rate 1.7700 and range 1.7100 1.8900. The strategy allows you to sell USD outright to the 6 months date at 1.8500, which is 0.0700 DEM per USD better than the regular market forward rate of 1.7800. Should spot however break the 1.7100 1.8900 range then the rate will automatically reset to 1.7700, which is 0.0100 DEM per USD less favourable than the market forward rate on the day that the trade was initiated. The range is considered broken if spot ever trades at or beyond either of the two reset triggers during the life of the strategy. Enhanced Hedge Rate Known Best/Worst Case Short Volatility The Range Reset Forward allows the hedger to improve his hedge rate by expressing the view that the underlying currency pair will be range bound for the duration of the strategy. The best and worst case of this hedging strategy is known in advance and equal to two specific rates, which is especially with respect to budgeting purposes of great convenience. This strategy allows the hedger to short volatility with limited risk. Using a Range Reset Forward you always remain hedged, either at a more favourable rate than the current market forward or at a slightly less favourable rate, should the prespecified range be breached. This allows you to think in terms of best and worst case scenarios. As this product behaves like a forward trade, you give up the profit potential if the exchange rate moves in favour of your underlying position. The holder of this forward must exchange currencies at the given forward level with the counterparty at expiration. Should a Range Reset Forward not appear to be attractive due to low implied volatilities or illiquidity of the underlying currency pair, the range can be chosen in a different currency pair for optimisation purposes (Dual Currency Range Reset Forward). 9
Kick In Option Hedger Sell an option to finance your hedging strategy and express the view that spot will not trade beyond a certain level. In addition to the strike this option has an instrike which is set in the in-the-money direction and the option will only come into existence if spot trades at or beyond the instrike during the life of the option. Selling the Kick In Option will always yield the investor less premium than the equivalent standard option. However, as this option is not alive unless spot trades at or beyond the instrike at any time before maturity, there is always the chance that the option will never exist. Market Data USD/DEM 1.8000 Forward 0.0200 Outright 1.7800 Data Expiry 6 months USD call/dem put Strike 1.8200 Instrike 1.9000 Premium 320 DEM pips 0.04 0.02 Instrike 0.00 0.02 0.04 0.06 0.08 1.80 1.82 1.84 1.86 1.88 1.90 1.92 of Kick In Option of standard option The option above expresses a bearish USD/DEM view, where the seller does not believe in spot going as high as 1.9000 at any point during the life of the option. With this strategy you take in upfront premium for selling a USD call/dem put option that does not exist unless spot trades at 1.9000 or higher during the life of the option. Due to the possibility that spot never reaches the instrike before maturity and the USD call never comes into existence, the upfront premium of the Kick In Option is slightly lower (320 DEM pips) than the upfront premium of the equivalent standard option (340 DEM pips). The option is considered kicked in if spot ever trades at or beyond the instrike during the life of the strategy. Contingent Obligation Financing Instrument Alternative to Risk Reversal The Kick In Option has a lower premium than the equivalent standard option would, but assuming the instrike has not been reached before maturity, the Kick In Option does not produce any obligation for the seller even if spot finishes in-the-money. The Kick In Option is a popular instrument with hedgers for the purpose of financing another option position. In most cases the Kick In Option is chosen to entirely finance the other position, thus making the strategy zero upfront premium. The Kick In Option is an attractive alternative to using the risk reversal structure as a financing vehicle for a hedge, in the sense that it offers different break even features. With the risk reversal your participation in a favourable spot movement is capped at the strike of the option you sell, whereas with the Kick In Option you participate up to the instrike, which is generally far in-the-money compared to the strike you are short in the equivalent risk reversal. The Kick In Option enables the hedger to earn premium by taking the view that spot will not reach a certain level during the option s life. Selling a Kick In Option instead of a standard option has the advantage, that there is always the possibility of spot not reaching the instrike before maturity, which means that the option never comes into existence. Should spot however reach the instrike before maturity, the hedger would have been better off selling the standard option since the upfront premium would have been slightly higher. For hedgers who do not want the instrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 10
Investor The foreign exchange market offers products with very high liquidity and around the clock trading hours. More and more investors look at foreign exchange as an asset class that offers attractive investment and trading opportunities, which in the past were often limited due to the lack of appropriate investment vehicles. However, with the introduction of Exotic Options these opportunities can now be exploited more effectively than ever. They allow investors to tailor their strategies with respect to expected spot patterns, the time horizon and premium contingency, thus creating an amount of leverage which would be impossible with taking positions in the spot or standard options market. More and more investors look at foreign exchange as an asset class that offers attractive investment and trading opportunities, which in the past were often limited due to the lack of appropriate investment vehicles. since the market for these products is very innovative and customer driven, such a list can never be extensive and include all the alternatives available to the investor. The list should however give you an idea of the vast opportunities made accessible thanks to Exotic Options. From the big variety of available products the following pages focus on those which we believe deserve special attention because they offer especially attractive features to the investor. However 11
Knock Out Option Investor Purchase an option to express your directional view. In addition to the strike this option has an outstrike which is set in the out-of-the-money direction. If spot reaches the outstrike before maturity, the option is terminated. In exchange for this possible give-up, the Knock Out Option premium is lower than the equivalent standard option premium. Market Data USD/JPY 121.00 Forward 1.65 Outright 119.35 Data Expiry 3 months USD call/jpy put Strike 123.00 Outstrike 118.00 Premium 120 JPY pips 4 2 0 2 Outstrike 113 118 123 128 of Knock Out Option of standard option This example of a Knock Out Option expresses a USD/JPY bullish view in the three months time frame. The strategy gives you the right but not the obligation to buy USD against JPY at 123.00 if spot never reaches the 118.00 outstrike. Should spot reach 118.00 before expiration then the Knock Out Option is automatically terminated. However at this point spot has moved against your initial view to the extent that you might want to take a stop loss and reassess market conditions anyway. Due to the possibility that the Knock Out Option is terminated before maturity its upfront premium is only 120 JPY pips, as opposed to the upfront premium of 170 JPY pips of the standard equivalent. This moves your break even from 124.70 with the standard option to 124.20 with the Knock Out Option. The option is considered knocked out if spot ever trades at or beyond the outstrike during the life of the strategy. Reduced Upfront Premium High Participation Long Vega Reduced Time Decay The upfront premium of the Knock Out Option is generally lower than that of the equivalent standard option. As long as spot fails to reach the outstrike the payoff of the Knock Out Option is equal to that of the standard option, which results in a better break even regardless of where spot finishes. If spot moves according to your view, without having reached the outstrike first, the Knock Out Option generally offers greater participation with spot movement than the equivalent standard option due to its higher delta. The holder of a Knock Out Option is generally long vega, meaning that the position gains in value if volatilities rise. The Knock Out Option generally loses in value with the passage of time, however, the decay is not as severe as with standard options. The Knock Out Option enables the investor to express a directional view for a reduced upfront premium. If the investor is right and spot starts to move in the anticipated direction, the Knock Out Option generally outperforms the standard option due to its higher delta and lower upfront premium. Should spot however reach the outstrike, retrace and finish in-the-money, you would have been better off with the standard option. For investors who do not want the outstrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 12
Kick Out Option Investor Purchase an option to express your mildly directional view. In addition to the strike this option has an outstrike which is set in the in-the-money direction, but beyond the scope of your view. If spot reaches the outstrike before maturity, the option is terminated. In exchange for this possible give-up, the Kick Out Option premium is significantly lower than the equivalent standard option premium. Market Data USD/CHF 1.4500 Forward 0.0100 Outright 1.4400 Data Expiry 2 months USD call/chf put Strike 1.4500 Outstrike 1.5000 Premium 30 CHF pips 0.075 0.055 0.035 0.015 0.005 0.025 Outstrike 1.40 1.45 1.50 1.55 of Kick Out Option of standard option The option above would suit a dollar bull that believes the USD has the scope to move higher against the CHF, but will not reach 1.5000. The strategy gives you the right but not the obligation to buy USD against CHF at 1.4500 if spot never reaches the 1.5000 outstrike. Should spot however reach 1.5000 before expiration then the Kick Out Option is automatically terminated, but at this point spot has moved beyond the scope of your initial view. Due to the possibility that the Kick Out Option is terminated before maturity and is always in-the-money if this happens, its upfront premium is only 30 CHF pips, as opposed to the upfront premium of 210 CHF pips of the equivalent standard option. The option is considered kicked out if spot ever trades at or beyond the outstrike during the life of the strategy. Reduced Upfront Premium Short Vega Positive Time Decay The upfront premium of the Kick Out Option is generally significantly lower than that of the equivalent standard option. As long as spot fails to reach the outstrike the payoff of the Kick Out Option is equal to that of the standard option which results in a better break even regardless of where spot finishes. The holder of a Kick Out Option is generally short vega, meaning the position gains in value if volatilities go lower. The short vega feature is due to the fact, that the lower the volatility the smaller the chance that spot reaches the outstrike before maturity. The Kick Out Option generally gains in value with the passage of time, all other things being equal. This means that unlike a standard option the Kick Out Option decays in the holder s favour. This is because the closer the option is to expiry, the less time there is for spot to reach the outstrike. The Kick Out Option enables the investor to take a highly leveraged mildly directional view. If the investor is right and spot finishes in-the-money without having reached the outstrike beforehand, he receives the same payoff as with the standard option, but for a significantly reduced upfront premium. Should spot however reach the outstrike before finishing in-the-money, the investor would have been better off owning the standard option since the Kick Out Option has been terminated and he loses his invested premium. The Kick Out Option usually has a low delta when first initiated and therefore only shows a low spot sensitivity. The delta, however, increases with the passage of time and therefore the spot sensitivity increases the closer the option gets to maturity. For investors who do not want the outstrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 13
Double Knock Out Option Investor Purchase an option to express your mildly directional/range trading view. In addition to the strike this option has two outstrikes which are set in the in-the-money and out-of-themoney direction. If spot reaches eitherof the outstrikes before maturity, the option is terminated. In exchange for this possible give-up, the Double Knock Out Option premium is significantly lower than the equivalent standard option premium. Market Data USD/DEM 1.8000 Forward 0.0040 Outright 1.7960 0.09 0.06 0.03 Outstrikes at 1.7700 & 1.8500 of Double Knock Out Option Data Expiry 1 month USD call/dem put Strike 1.7900 Outstrikes 1.7700 & 1.8500 Premium 35 DEM pips 0.00 0.03 1.75 1.77 1.79 1.81 1.83 1.85 1.87 1.89 of standard option The option above would suit an investor who believes the USD has the scope to move moderately higher against the DEM, but will reach neither 1.8500 nor 1.7700. The strategy gives you the right but not the obligation to buy USD against DEM at 1.7900 if spot never reaches either of the outstrikes. Should spot however reach 1.7700 or 1.8500 before expiration then the Double Knock Out Option is automatically terminated, but at this point spot has moved against your initial view. Due to the possibility that the Double Knock Out Option is terminated before maturity, its upfront premium is only 35 DEM pips, as opposed to the upfront premium of 270 DEM pips of the equivalent standard option. The option is considered knocked out if spot ever trades at or beyond either of the two outstrikes during the life of the strategy. Reduced Upfront Premium Short Vega Positive Time Decay The upfront premium of the Double Knock Out Option is generally significantly lower than that of the equivalent standard option. As long as spot fails to reach either of the two outstrikes the payoff of the Double Knock Out Option is equal to that of the standard option which results in a better break even regardless of where spot finishes. The holder of a Double Knock Out Option is generally short vega, meaning the position gains in value if volatilities go lower. The short vega feature is due to the fact, that the lower the volatility the smaller the chance that spot reaches either of the outstrikes before maturity. The Double Knock Out Option generally gains in value with the passage of time, all other things being equal. This means that unlike a standard option the Double Knock Out Option decays in the holder s favour. This is because the closer the option is to expiry, the less time there is for spot to reach the outstrikes. The Double Knock Out Option enables the investor to take a highly leveraged mildly directional view. If the investor is right and spot finishes in-the-money without having reached either of the outstrikes beforehand, he receives the same payoff as with the standard option, but for a significantly reduced upfront premium. Should spot however reach either of the outstrikes before finishing in-the-money, the investor would have been better off owning the standard option since the Double Knock Out Option is terminated and he loses the invested premium. The Double Knock Out Option usually has a low delta when first initiated and therefore only shows a low spot sensitivity. The delta, however, increases with the passage of time and therefore the spot sensitivity increases the closer the option gets to maturity. For investors who do not want the outstrikes to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barriers only active during a prespecified period of time. 14
Kick In Option Investor Sell an option to finance your investment strategy and express the view that spot will not trade beyond a certain level. In addition to the strike this option has an instrike which is set in the in-the-money direction and the option will only come into existence if spot trades at or beyond the instrike during the life of the option. Selling the Kick In Option will always yield the investor less premium than the equivalent standard option. However, as this option is not alive unless spot trades at or beyond the instrike at any time before maturity, there is always the chance that the option will never exist. Market Data DEM/JPY 68.00 Forward 0.50 Outright 67.50 Data Expiry 3 months DEM call/jpy put Strike 69.00 Instrike 72.00 Premium 79 JPY pips 1.00 0.00 1.00 2.00 3.00 4.00 5.00 Instrike 68 69 70 71 72 73 74 of Kick In Option of standard option The option above expresses a bearish DEM/JPY view, where the seller does not believe in spot going as high as 72.00 at any point during the life of the option. With this strategy you take in upfront premium for selling a DEM call/jpy put option that does not exist unless spot trades at 72.00 or higher during the life of the option. Due to the possibility that spot never reaches the instrike before maturity and the DEM call never comes into existence, the upfront premium of the Kick In Option is slightly lower (0.79 JPY) than the upfront premium of the equivalent standard option (0.89 JPY). The option is considered kicked in if spot ever trades at or beyond the instrike during the life of the strategy. Contingent Obligation Short Vega Financing Instrument The Kick In Option generates a lower premium than the equivalent standard option but, assuming the instrike has not been reached before maturity, the Kick In Option does not produce any obligation for the seller even if spot finishes in-the-money. The seller of a Kick In Option is generally short vega, meaning the position gains in value if volatilities go lower. The short vega feature is due to the fact, that the lower the volatility the smaller the chance that spot reaches the instrike before maturity. The Kick In Option is a popular instrument with investors for the purpose of financing another option position. In most cases the Kick In Option is chosen to entirely finance the other position, thus making the strategy zero upfront premium. The Kick In Option enables the investor to take in some premium by taking the view that spot will not reach a certain level during the option s life. Selling a Kick In Option instead of a standard option has the advantage, that there is always the possibility of spot not reaching the instrike before maturity, which means that the option never comes into existence. Should spot however reach the instrike before maturity, the investor would have been better off selling the standard option since the upfront premium would have been slightly higher. For investors who do not want the instrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 15
Parity Out Option Investor Purchase an option to express your directional view. In addition to the strike this option has an outstrike which is set in the out-of-the-money direction. If spot reaches the outstrike before maturity, the option is terminated. The Parity Out Option differs from the regular Knock Out Option in the sense that the barrier is set so the option is still in-themoney when it is terminated. In exchange for this possible give-up, the Parity Out Option premium is lower than the equivalent standard option premium. Market Data GBP/DEM 2.8500 Forward 0.0185 Outright 2.8315 Data Expiry 2 months GBP put/dem call Strike 2.9500 Outstrike 2.9000 Premium 860 DEM pips 0.15 0.10 0.05 0.00 0.05 0.10 0.15 Outstrike 2.75 2.80 2.85 2.90 2.95 3.00 of Parity Out Option of standard option This example of a Parity Out Option expresses a GBP/DEM bearish view in the two months time frame. The strategy gives you the right but not the obligation to sell GBP against DEM at 2.9500 if spot never reaches the 2.9000 outstrike. Should spot reach 2.9000 before expiration then the Parity Out Option is automatically terminated. However, at this point spot has moved against your initial view to the extent that you might want to take a stop loss and reassess market conditions anyway. Due to the possibility that the Parity Out Option is terminated before maturity its upfront premium is only 860 DEM pips, as opposed to the upfront premium of 1280 DEM pips of the standard equivalent. The option is considered knocked out if spot ever trades at or beyond the outstrike during the life of the strategy. Another interesting feature of this strategy is the delta of 150 as opposed to 85 for the standard option. Reduced Upfront Premium High Participation Short Vega Positive Time Decay The upfront premium of the Parity Out Option is generally lower than that of the equivalent standard option. As long as spot fails to reach the outstrike the payoff of the Parity Out Option is equal to that of the standard option which results in a better break even regardless of where spot finishes. With the Parity Out Option it is possible to have a delta which is higher than 100. In these cases the option gains in value faster than a spot position, which only gains 1 to 1 with a favourable spot movement. The holder of a Parity Out Option is generally short vega, meaning the position gains in value if volatilities go lower. The short vega feature is due to the fact, that the lower the volatility the smaller the chance that spot reaches the outstrike before maturity. The Parity Out Option generally gains in value with the passage of time, all other things being equal. This means that unlike a standard option the Parity Out Option decays in the holder s favour. This is because the closer the option is to expiry, the less time there is for spot to reach the outstrike. The Parity Out Option enables the investor to express a directional view for a reduced upfront premium. If the investor is right and spot starts to move in the desired direction, the Parity Out Option generally outperforms the standard option due to its higher delta and lower upfront premium. In addition, should spot fail to move, the position will gain in value with time, making the trade profitable even if spot just sits. Should spot however reach the outstrike, retrace and finish in-the-money, you may have been better off with the standard option. For investors who do not want the outstrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 16
Knock Out Forward Investor Enter into a Knock Out Forward contract to express your mildly directional view. The Knock Out Forward is a standard forward that automatically terminates if spot trades at or beyond a predetermined outstrike before the cut-off date (2 days prior to settlement). In exchange for this possible give-up, the forward level of the Knock Out Forward is set at a more favourable rate than the ordinary market forward outright. Generally the Knock Out Forward is structured for zero upfront premium. Market Data GBP/DEM 2.8450 Forward 0.0100 Outright 2.8350 Data Expiry 1 month Forward rate 2.8600 Outstrike 2.7500 Premium zero upfront premium 0.12 0.10 0.08 0.06 0.04 0.02 0 0.02 0.04 0.06 0.08 Outstrike 2.72 2.74 2.76 2.78 2.80 2.82 2.84 2.86 2.88 2.90 of Knock Out Forward of Market Forward The above position would suit a GBP/DEM bearish investor who believes that spot will head lower but not as far as 2.7500. It allows the holder to sell GBP against DEM outright at 2.8600 as long as spot never reaches 2.7500 before the cut-off date. Should spot however reach 2.7500 during the life of the strategy then the Knock Out Forward is automatically terminated, but at this point spot has moved beyond the scope of the initial view. Due to the possibility that the Knock Out Forward is terminated before settlement, its forward rate is set 0.0250 DEM per GBP more favourable (2.8600 DEM per GBP) than the ordinary market forward (2.8350 DEM per GBP). The Knock Out Forward is considered knocked out if spot ever trades at or beyond the outstrike during the life of the strategy. Enhanced Forward Rate Short Vega Positive Time Decay The Knock Out Forward is generally structured for zero upfront premium such that the holder gets long (or short) the underlying currency at a rate substantially better than the current market forward outright rate for zero cost. The holder of a Knock Out Forward is generally short vega, meaning the position gains in value if volatilities go lower. The short vega feature is due to the fact, that the lower the volatility the smaller the chance that spot reaches the outstrike before maturity. The Knock Out Forward generally gains in value with the passage of time, all other things being equal. This is because the closer the Knock Out Forward is to the cut-off date, the less time there is for spot to reach the outstrike. The Knock Out Forward enables the investor to take a highly leveraged mildly directional view. If the investor is right and spot finishes in the anticipated area without having reached the outstrike beforehand, he receives a significantly higher payoff than with the market forward. Should spot however reach the outstrike before maturity, the investor would have been better off owning the regular forward since the Knock Out Forward has been terminated whereas the regular forward could be reversed for profit. In addition to the risk that the Knock Out Forward is terminated before maturity the instrument has the same unlimited loss potential as the regular forward. For investors who do not want the outstrike to be active during the entire life of the strategy, the windowed barrier family offers the possibility to have the barrier only active during a prespecified period of time. 17
Double Lock Out Option Investor Purchase an option to express your view that spot will be range bound for a certain period. The buyer of the Double Lock Out Option receives a fixed payout if spot stays inside a prespecified range during the entire life of the option. If spot reaches either of the outstrikes before maturity, the option is terminated. Market Data USD/JPY 121.00 Forward 1.60 Outright 119.40 100 80 60 40 Outstrikes 116.00 & 126.00 Payoff at expiry of Double Lock Out Option 20 Data Expiry 3 months Payout 100,000 USD Outstrikes 116.00 & 126.00 Premium 18% of payout or 18,000 USD 0 0.20 113 118 123 128 This strategy suits the investor who believes that 116.00 126.00 is going to be the range for USD/JPY for the next three months. The holder of this Double Lock Out receives 100,000 USD payout if spot stays within the range during the entire life of the strategy. Should spot ever reach 116.00 or 126.00 before expiration the Double Lock Out Option is automatically terminated and the investor loses the right to receive the payout and the invested premium. The option is considered knocked out if spot ever trades at or beyond either of the two outstrikes during the life of the strategy. Risk/Reward Short Vega Positive Time Decay Due to its fixed upfront premium and possible final payout the Double Lock Out Option enables the investor to think in terms of risk/reward. The holder of a Double Lock Out Option is generally short vega, meaning the position gains in value if volatilities go lower. The short vega feature is due to the fact, that the lower the volatility the smaller the chance that spot reaches either of the outstrikes before maturity. The Double Lock Out Option generally gains in value with the passage of time, all other things being equal. This means that unlike a standard option the Double Lock Out Option decays in the holder s favour. This is because the closer the option is to expiry, the less time there is for spot to reach the outstrikes. The Double Lock Out Option enables the investor to take a highly leveraged range trading view. If the investor is right and spot does not touch either of the barriers, he receives the payoff. This strategy is especially popular with investors who want to express a short volatility view because unlike selling standard options to sell volatility, the Double Lock Out Option has a downside risk which is limited to the upfront premium. Should spot reach either of the outstrikes before maturity the investor loses the right to receive the payout as well as the invested premium. For investors who would like to diversify the termination risk associated with being long a Double Lock Out Option to different spot levels the Quattro Option gives the opportunity to choose four consecutively wider spot ranges. For every range that holds until expiry the investor receives 25 per cent of the maximum possible payout. 18
One Touch Option Investor Purchase an option to express your directional view. The One Touch Option pays out a fixed amount if and only if spot trades at or beyond a prespecified trigger before expiration. Market Data DEM/JPY 68.00 Forward 0.15 Outright 67.85 Data Expiry 1 month Payout 100,000 DEM Trigger 71.00 Premium 22% of payout or 22,000 DEM 100 80 60 40 20 0 20 40 Trigger 65 67 69 71 73 of One Touch Option The above One Touch Option would suit an investor who believes the DEM has the scope to move sharply higher against the JPY in the near term. The strategy gives you the right to receive a fixed payout of 100,000 DEM if spot reaches 71.00 within the next month. Should spot however fail to reach 71.00 before expiration the One Touch Option expires worthless and the investor loses the initial premium. Risk/Reward Long Vega High Participation Due to its fixed upfront premium and possible final payout the One Touch Option enables the investor to think in terms of risk/reward. The holder of a One Touch Option has a long vega position, which means that the value of the position increases as volatilities rise. This is due to the fact that the higher the volatility the higher the chance is that spot will touch the trigger before expiration. Due to its high sensitivity to spot movement the One Touch Option enables the investor to close out early for a profit, should spot move in the investor s favour. This has to be kept in mind when comparing the One Touch Option with the generally cheaper bull- or bearspread, which only lets you participate in a favourable spot movement close to expiration of the option position. The One Touch Option enables the investor to take a highly leveraged directional view. If the investor is right and spot reaches the trigger, he receives a fixed payout. However, the investor does not have to hold the option until expiry because due to its high spot sensitivity the One Touch Option can be closed early for profit if spot moves favourably. Should spot however fail to reach the trigger before maturity, the One Touch Option expires worthless and the investor loses the premium paid. The One Touch Option usually has a high delta when first initiated and therefore shows a high spot sensitivity. The delta, however, decreases with the passage of time and therefore the spot participation decreases the closer the option gets to maturity. For investors who would like to take on a little more leverage, an outstrike can be added to the One Touch Option. The added outstrike reduces the upfront premium but introduces the risk that the option is terminated before maturity if spot reaches the outstrike before the trigger. 19
Digital Option Investor Purchase an option to express your directional view. The Digital Option pays out a fixed amount at maturity if and only if spot finishes above (Digital Call) or below (Digital put) a prespecified level (the strike). Market Data DEM/CHF 0.8200 Forward 0.0040 Outright 0.8160 100 75 50 25 Digital Strike of Digital Option Data Expiry 3 months Payout 100,000 CHF Strike 0.8280 Premium 25% of payout or 25,000 CHF 0 25 50 0.812 0.82 0.828 0.836 0.844 The above Digital Option would suit an investor who believes the DEM will slowly grind higher against the CHF during the next three months and finish above 0.8280. The strategy gives you the right to receive a fixed payout of 100,000 CHF if spot finishes above the strike within the next three months. Should spot however finish below the strike the Digital Option expires worthless and the investor loses the initial premium. Risk/Reward Long Vega Highly Leveraged Due to its fixed upfront premium and possible final payout the Digital Option enables the investor to think in terms of risk/reward. The holder of an out-of-the-money Digital Option has a long vega position, which means that the value of the position increases as volatilities rise. This is due to the fact that the higher the volatility the higher the chance that spot is going to finish beyond the strike. The Digital Option generally has a higher payout to premium ratio than the equivalent One Touch or standard option enabling the investor to take a highly leveraged position. The Digital Option gives the investor the opportunity to express a directional view with an excellent payout to premium ratio. If spot finishes just beyond the strike, the buyer gets the entire payout amount, whereas with the equivalent standard option spot has to finish way in-the-money to give the same profit. When compared to the equivalent One Touch Option the premium of the Digital Option is generally substantially lower, which is due to the fact that with the One Touch Option spot only has to reach the instrike once, where-as with the Digital Option spot has to be beyond the strike in order for the investor to receive the payout. If spot does not finish beyond the strike, the Digital Option expires worthless and the investor loses the premium paid. For investors who would like to take on a little more leverage, an outstrike can be added to the Digital Option. The added outstrike reduces the upfront premium but introduces the risk that the option is terminated before maturity if spot reaches the outstrike. 20
Glossary At-the-money Barrier Transaction Delta Expiry Gamma Instrike In-the-money Option Premium Out-of-the-money Outstrike Payout Amount Standard Option Strike Theta Trigger Vega Volatility An option (Put & Call) is at-the-money if the strike price is equal to the forward rate A spot transaction that is at or beyond the in- or outstrike Shows the change of the option s value with respect to a change in the underlying spot rate Date where the option expires. If the holder of the option does not exercise, it will expire worthless Shows the change of the option s delta with respect to a change in the underlying spot rate If this prespecified spot level is touched, the underlying option becomes alive A Call Option is in-the-money if the strike price is lower than the forward rate A Put Option is in-the-money if the strike price is higher than the forward rate Premium the buyer of the option pays to the seller A Call Option is out-of-the-money if the strike price is higher than the forward rate A Put Option is out-of-the-money if the strike price is lower than the forward rate If this prespecified spot level is touched, the underlying option ceases to exist Cash amount the buyer of the option receives if a prespecified event occurs Regular Call or Put option with no exotic features (also called plain vanilla option) Price at which the underlying will be exchanged at expiration if the holder of the option decides to exercise the option Shows the change of the option s value with respect to a change in the time to expiration by one day level which constitutes a certain event if traded Shows the change of the option s value with respect to a change in the implied volatility Volatility is a factor used to calculate the option premium and is a measure for the distribution of future spot rates. It is a traded commodity and the price is determined by demand and supply in the market 21
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Issued by UBS AG, acting through its financial services group UBS Warburg, regulated by the Securities and Futures Authority in the UK and a member of the London Stock Exchange. Investors should be aware, however, that the regulatory regime and any investor compensation scheme or arrangements applicable to the options described herein may not be that of the UK. Investment in options involves a high degree of risk. The value of option positions can fall rapidly. Options may not be suitable investments for all investors and investors should seek professional investment advice about the suitability of all investments to their needs before entering into any investment agreement. Changes in rates of exchange may have an adverse effect on the value or price of foreign exchange option positions. It may be difficult for investors to unwind or realise the value of their option positions and obtain reliable information about the value of or the extent of the risk to which the positions are exposed. Sellers of foreign exchange options give the purchaser the right to call for the seller to purchase or sell the underlying currency at a price which may be far higher or lower than market price at the time. This document is provided for information purposes only. It is not intended to be an offer or solicitation of an offer to buy or sell any financial product. No representation or warranty is given herein or otherwise as to the accuracy or completeness of the information contained herein. 2000. All rights reserved. No part of this document may be reproduced or distributed in any manner without the written permission of UBS AG. The redistribution of this document in any manner is specifically prohibited and no liability whatsoever is accepted for the actions of third parties in this respect. This document may not be distributed to private clients outside Switzerland. This document is not intended for distribution in the USA and/or to US-persons. UBS Warburg is a financial services group of UBS AG
UBS AG P.O. Box CH-8098 Zurich Domicile: Europastrasse 1 and 2 CH-8152 Opfikon UBS Warburg is a financial services group of UBS AG This environnment-friendly paper has been produced using pulp bleached without chlorine. Printed in June 2000. 80352E