How Do Banks Make Money From Foreign Exchange

Foreign Exchange

John Hill , in FinTech and the Remaking of Financial Institutions, 2018

Fintech Applications

There are many Fintech opportunities in foreign exchange. The markets are large, there are many different customer segments, and bid-ask and transaction charges by the large institutions are significant. However, the large banks have the advantages of large capital bases, substantial client flow, global networks, and licenses. Consequently, relative to the total size of the market, Fintech successes in foreign exchange have so far been modest, but some of the more interesting applications are discussed below.

While the currency spot and forward market volumes are dominated by large institutional transactions, there is a significant need for smaller scale currency transfers by individuals and small businesses. Bank charges for these transactions can be quite high. In the past, some UK banks would charge up to £30 to send a payment of as little as £10 abroad. These substantial fees present an opportunity for Fintech disintermediation. Like peer-to-peer (P2P) lending, P2P foreign exchange has appeared on the scene, reducing the costs for many consumers. Instead of the two sides separately going to a bank for their currency transactions, they find each other through the much cheaper services of the Fintech app. The transactions are similar to the currency swap explained above, but the transaction size is much smaller. These new P2P currency exchanges match the needs of an individual or small business in one country with an individual or small business which has offsetting needs in another country. TransferWise is one of the more successful of these P2P exchanges. Over 1 million people use TransferWise to send more than $1.2 billion every month from 60 countries. It is available on an easy-to-use mobile app which won the award of "Most Innovative 2015" from Apple. It typically charges 0.5% for a transaction. This is much cheaper than typical bank fees of 3%–5% for small transfers.

A second Fintech company in this space is Xoom, which was acquired by PayPal in July 2015 for $890 million. Xoom enables customers in the United States to send money to, and pay bills for, family and friends around the world using their mobile phones, tablets, or computers.

Another is WorldRemit which lets users in 50 countries send money, and people in 117 countries receive it. The funds can be transferred to bank accounts, cash pick-up points, or into mobile wallets.

SettlePay not only offers similar currency services but provides customers with an analytic capability to estimate the 'true" cost of previous currency transactions. Founded in 2015, SettlePay is a Nottingham, London, and Singapore-based start-up and wholly owned subsidiary of Fintech firm, Whites Group. To see what a previous transaction really cost, a user enters details of any past foreign exchange transaction into the SettlePay dashboard. The platform then uses historic, interbank rate data which estimates the cost of foreign currency to the provider at the exact time of each transaction. The user can then compare the actual rate and other charges to this implied cost. SettlePay (and the other Fintech providers) believes that the total costs charged by banks to consumers will be shown to be far more than what these disrupters charge. In SettlePay's published schedule, the transaction charges are 0.3% fixed rate on all transactions over £10,000 and for all transactions below £10,000, a £10 fee is added to the 0.3% fixed rate. SettlePay claims that its fees are 89% cheaper than the average high street bank on a £100,000 GBP to USD transaction.

One other interesting company is InstaRem. InstaRem is headquartered in Singapore and focuses on the international remittance markets in Asia. It has backing from among others, a subsidiary of Singapore's sovereign wealth fund, Temasek. It began first in Australia and holds licenses in Singapore, Malaysia, Japan, Luxemburg, and several US states. It has average transaction size of $1800 and charge rates of less than 1%. What is different about this company is that it works with mid-sized banks. TransferWise and other competitors look to use offsetting customer transactions to facilitate currency transfers. InstaRem instead works with mid-size banks with an existing presence in the overseas currency transfer business. These banks see the value of InstaRem's origination and introduction to individuals, and small and mid-size businesses. These modest currency transfers can be seen as opening the door to potential future transactions which might be more profitable for the banks.

Cryptocurrencies such as Bitcoin, Ethereum, and others can also be used as a means of exchanging currency. A trader can buy the cryptocurrency using a domestic currency, say USD and use it to buy goods in Euros. The trader could also buy the cryptocurrency in USD, then sell it for Euros and deposit the proceeds in an online wallet in a different currency. There are reports that these cryptocurrencies have had significant usage in countries such as China and Venezuela where government controls restrict currency flows out of the country. The cryptocurrencies present a convenient means of evading these controls, offering a market opportunity but also presenting a significant risk of enforcement actions to prevent money laundering and other illegal acts.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780128134979000093

Foreign Exchange Markets and Triggers for Bank Risk in Developing Economies

Leonard Onyiriuba , in Bank Risk Management in Developing Economies, 2016

Overview of the subject matter

Foreign exchange risk is defined as "the risk of holding or taking positions in foreign currencies, including gold." ( Basel Committee, 2005:23). It also refers to the danger that a bank might lose money on a lending, or foreign currency transaction due to unanticipated adverse changes in exchange rates. Due to weak currencies, bank in emerging economies deal with exchange rate issues on daily basis. In fact, foreign exchange gains or losses occasioned by volatile exchange rates determine to a large extent financial performance of banks in emerging markets. Thus most banks in emerging economies are very active in both official and autonomous foreign exchange markets. Unfortunately, majority of the issues regulatory authorities have with banks in emerging economies result from sharp practice in the foreign exchange markets.

Developing countries have over the years pursued elusive economic reform programs aimed at achieving realistic exchange rates through free interplay of market forces. Economic and monetary authorities argue that overvaluation of domestic currencies discourages inflow of foreign investments. It is further argued that currency overvaluation penalizes export production. Measured by the difference between official nominal and parallel market exchange rates, overvaluation of domestic currencies became so high that devaluation was the first step in structural adjustment programs (SAPs) of the countries. However, the immediate effect of devaluation was a rise in inflation rate, crystallizing the major burden of adjustment on the poor. The strategy of export promotion is to depreciate domestic currencies, stop the marketing of agricultural produce through monopolistic public sector agencies, and establish export-processing zones.

Depreciation enhances the prices of local currency earnings from exports. Abolition of public sector commodities marketing agencies achieves efficient pricing of exports and maximizes returns to the farmers. Export processing zones are designed to encourage greater export production. However, the benefits of these measures are sometimes diminished by conflicting macroeconomic policies targeted at other sectors of the economy, particularly in foreign exchange and interest rate management. In Nigeria, for instance, export production was discouraged in the early 1990s by the adoption of a fixed exchange rate regime meant to regain public confidence in the country's domestic currency—the naira. However, parallel foreign exchange markets subsisted—sometimes getting funds illegally from the official market.

Foreign exchange problems of developing countries derive, to a large extent, from occasional and unexpected economic shocks. The volatility of international oil market is a case in point. The same goes for fluctuation causing depression in nonoil, especially primary, commodities market. These situations adversely affect foreign exchange earnings and reserves. All this weakens efforts to regenerate the economies. Often the fate of the economies and government policies are closely intertwined. Massive external borrowing to finance development projects designed to improve domestic industry and infrastructure exacerbates the problem. For example, from an estimated $6 billion in 1970, the aggregate external debt of sub-Saharan Africa grew to more than $126 billion in 1987. The real GDP per capita of the countries plummeted by about 11% over the same period. Commentators on economic crisis of developing countries—especially occasional papers and reports of the World Bank and IMF officials, as well as commentaries from international economic monitors and institutions—tend to focus on adverse domestic and external shocks, as well as faulty domestic policies.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780128054796000249

Stock Markets, Derivatives Markets, and Foreign Exchange Markets

Rajesh Kumar , in Strategies of Banks and Other Financial Institutions, 2014

5.3.8 Foreign Exchange Risk Management

Foreign exchange risk is also known as exchange rate risk or currency risk. This risk arises from unanticipated changes in the exchange rate between two currencies. Multinational companies, export import businesses, and investors making foreign investments face exchange rate risks. When a currency falls in value in relation to other currencies, the currency is said to depreciate in value, and when the currency rises in value relative to other currencies, it is said to appreciate in value. Goods and services in countries where the currency has depreciated will become cheaper for foreign buyers. In the case of currency appreciation, a country's goods and services become more expensive for foreign buyers.

Foreign exchange risks can be classified into economic and translation exposure. Economic exposure refers to risks in which changes in economic conditions will adversely impact the investments or operations of a firm. For example, sovereign debt default by a country would affect the exchange rate of the currency. Economic exposure leads to possible changes in the firm's cash flows. The unexpected changes in the exchange rate will affect the market value of the firm. Economic exposure is the combination of transaction exposure and operating exposure. Transaction exposure arises when the future cash flows of the firm are affected by changes in the currency exchange rate. It is the gain or loss arising when converting the currencies. Companies involved in imports and exports face transaction exposure. Managing transaction exposure is an integral part of the Treasury risk management function of corporations. Operating exposure is the degree of risk that a company is exposed to when shifts in exchange rates affect the value of certain assets of the business thereby impacting the overall profitability of the company.

Translation exposure is also known as accounting exposure. Accounting exposure measures the impact of changes in exchange rate on the financial statements of a company. Translation exposure arises when the financial statements of overseas subsidiaries are consolidated into a parent company's financial statement. The performance of an overseas subsidiary in home-based currency can be affected to a greater extent if the exchange rate fluctuation happens in relation to the currency in which the subsidiary cash flows occur.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780124169975000051

China Investment Corporation: China's Sovereign Wealth Fund

Yuwei Hu , in Handbook of Asian Finance: Financial Markets and Sovereign Wealth Funds, 2014

18.5.1 Better Coordination Between SAFE and the Ministry of Finance

The relationship between SAFE and the Ministry of Finance plays a crucial role in the setup and the further development of the CIC. Therefore, it would be important to coordinate the relationship between both institutions in a more efficient manner. A regular coordination mechanism should be in place which could be achieved by either signing a formal memorandum of understanding or via legislation. If there is any specific task involving both parties, then it would be also advisable to form a joint task force to work together. Furthermore, the senior management team at the CIC is still controlled by the Ministry of Finance, for example, both the predecessor and incumbent Chairmen of CIC are from the Ministry of Finance, while SAFE is only represented in CIC with a few independent board directors. Given this observation, it would be helpful if the CIC could give up some power and leave one or two senior executive positions to the discretion of SAFE.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780128009826000184

Foreign Exchange Risk and Forecasting

Michael Melvin , Stefan Norrbin , in International Money and Finance (Ninth Edition), 2017

Summary

1.: Foreign exchange risk includes translation exposure, transaction exposure, and economic exposure.
2.: Foreign exchange risk could be minimized by trading in forward-looking market instruments, invoicing prices in domestic currency, speeding payments of currencies expected to appreciate, and speeding collections of currencies expected to depreciate.
3.: The foreign exchange risk premium is the difference between the forward exchange rate and the expected future spot exchange rate.
4.: A risk-averse investor will prefer an investment with a lower risk when he/she faces two investments of similar expected returns.
5.: The difference between the return on a domestic asset and the effective return on a foreign asset depends on the risk of the assets and the degree of risk aversion.
6.: The effective return differential is equal to the risk premium in the forward exchange market.
7.: If the effective return differential is zero, then there would be no risk premium. If the effective return differential is positive, then there would be a positive risk premium on the domestic currency.
8.: If a positive risk premium on the domestic currency exists, investors would be willing to hold foreign investments even if the foreign investments yield lower effective returns than the domestic investments.
9.: In an efficient market, prices reflect all available information. If the foreign exchange market is efficient, the forward exchange rate would differ from the expected future spot exchange rate only by a risk premium.
10.: For multinational firms, a good forecast is not necessarily minimizing forecasting errors, but it should be on the correct side of the forward exchange rate.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780128041062000083

FORECASTING RISK AND RETURN

Michel M. Dacorogna , ... Olivier V. Pictet , in An Introduction to High-Frequency Finance, 2001

9.3.1 Intrinsic Time

The foreign exchange returns exhibit conditional heteroskedasticity which can be treated through a change of time scale. This is the second layer of our forecasting model on top of the business time ϑ-scale. Some literature followed a similar approach to treat the conditional heteroskedasticity, such as Stock (1988), who uses two types of time deformation, one based on the time series itself and one on business cycle variables. ⁵ In our approach, we also use the underlying time series to construct a time deformation. It is based on the scaling law defined in Equation 6.2 and on the price volatility:

(9.7) $τ (t_{c}) \equiv τ (t_{c - 1}) + k \frac{ϑ (t_{c}) - ϑ (t_{c} - 1)}{Δ ϑ} \frac{{| Δ x |}^{E}}{c}$

where t _c is the current time, the price difference is taken on the same interval as Δϑ, and E and c are the scaling law inverse exponent and factor, respectively. The constant k is a calibration factor dependent on the particular time series. Its role is to keep τ in line with physical time in the long run. This relationship is in fact the reverse of the scaling law for a particular return taken on a constant ϑ-time interval size.

This second new time scale, the τ-scale, does not directly use the physical time t, and does not need to have fundamental information about the behavior of the series. The only information needed to define the scale are the values of the time series themselves. Thus we have chosen to call this time scale intrinsic time. The consequence of using such a scale is to expand periods of high volatility and contract those of low volatility, thus better capturing the relative importance of events to the market. Any moving average based on the intrinsic time τ dynamically adapts its range to market events. Therefore a forecasting model based on the τ-scale has a dynamic memory of the price history.

There is, however, a problem when using such a time scale. The intrinsic time τ is only known for the past, contrary to the business time scale ϑ, which is known also for the future, because it is based on average behavior. Thus a forecasting model for the price actually needs to be composed of two forecasting models, one for the intrinsic time and one for the price. The first requires forecasting of the size (not the direction) as time cannot flow backward.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780122796715500125

The Foreign Exchange Market

Michael Melvin , Stefan Norrbin , in International Money and Finance (Ninth Edition), 2017

Short-Term Foreign Exchange Rate Movements

Understanding the "market microstructure" allows us to explain the evolution of the foreign exchange market in an intradaily sense, in which foreign exchange traders adjust their bid and offer quotes throughout the business day.

A foreign exchange trader may be motivated to alter his or her exchange rate quotes in response to changes in his or her position with respect to orders to buy and sell a currency. For instance, suppose Helmut Smith is a foreign exchange trader at Deutsche Bank, who specializes in the dollar/euro market. The bank management controls risks associated with foreign currency trading by limiting the extent to which traders can take a position that would expose the bank to potential loss from unexpected changes in exchange rates. If Smith has agreed to buy more euros than he has agreed to sell, he has a long position in the euro and will profit from euro appreciation and lose from euro depreciation. If Smith has agreed to sell more euros than he has agreed to buy, he has a short position in the euro and will profit from euro depreciation and lose from euro appreciation. His position at any point in time may be called his inventory. One reason traders adjust their quotes is in response to inventory changes. At the end of the day most traders balance their position and are said to go home "flat." This means that their orders to buy a currency are just equal to their orders to sell. Thus, the profit the bank receives is from trading activity, not from speculative activity.

FAQ: What Is a Rogue Trader?

Many bank traders are required to balance their positions daily. This is done to eliminate the risk that the overnight position changes in value dramatically. Note that in the arbitrage case the buying and selling is almost instantaneous. Therefore, there is practically no risk. The longer one has to wait for an offsetting position, the more risk there is. Thus, there is a speculative risk when a bank adopts a one-sided bet. An overnight position would be too much risk for most banks to accept, as this is a high-risk speculation.

However, banks have been subject to fraud at times where they seem to be unable to control what traders do. If traders take on their own bets in exception to the bank's risk controls then they have become "rogue traders." In September 2011, UBS bank discovered that one of their traders, Kweku Adoboli, had entered into upward of $10 billion in trades with fictitious offset trades. Effectively this created risky positions that lost UBS as much as $2.3 billion.

The most famous "rogue trader" is Nick Leeson, who lost $1.3 billion while working for Barings Investment bank in the early 1990s. He bought futures contracts without any offsetting transactions, claiming that they were purchase orders on behalf of a client. The loss to Barings Investment bank was so high that the well-respected bank that had existed over 200 years had to declare bankruptcy. Nick received a prison sentence in a Singapore jail for 6.5 years. For more on the life of Nick Leeson, see Leeson (2011) or watch Ewan McGregor starring as Nick Leeson in the movie Rogue Trader.

Let us look at an example. Suppose Helmut Smith has been buying and selling euros for dollars throughout the day. By early afternoon his position is as follows:

dollar purchases: $100,000,000

dollar sales: $80,000,000

In order to balance his position, Smith will adjust his quotes to encourage fewer dollar purchases and more dollar sales. For instance, if the euro is currently trading at $1.4650–60, then Helmut could raise the bid and offer quotes to encourage others to sell him euros in exchange for his dollars, while deterring others from buying more euros from him. For instance, if he changes the quote to 1.4655–65, then someone could sell him euros (or buy his dollars) for $1.4655 per euro. Since he has raised the dollar price of a euro, he will receive more interest from people wanting to sell him euros in exchange for his dollars. When Helmut buys euros from other traders, he is selling them dollars, and this helps to balance his inventory and reduce his long position in the dollar. At the same time Helmut has raised the sell rate of euros to $1.4665. This discourages other traders from buying more euros from Helmut (giving him dollars as payments).

This inventory control effect on exchange rates can explain why traders may alter their quotes in the absence of any news about exchange rate fundamentals.

In addition to the inventory control effect, there is also an asymmetric information effect, which causes exchange rates to change due to traders' fears that they are quoting prices to someone who knows more about current market conditions than they do. Even without news regarding the fundamentals, information is being transmitted from one trader to another through the act of trading. If Helmut posts a quote of 1.0250–260 and is called by Ingrid Schultz at Citibank asking to buy $5 million of euros at Helmut's offer price of 1.0260, Helmut then must wonder whether Ingrid knows something he doesn't. Should Ingrid's order to trade at Helmut's price be considered a signal that Helmut's price is too low? What superior information could Ingrid have? Every bank receives orders from nonbank customers to buy and sell currency. Perhaps Ingrid knows that her bank has just received a large order from Daimler Benz to sell dollars, and she is selling dollars (and buying euros) in advance of the price increase that will be caused by this nonbank order being filled by purchasing euros from other traders.

Helmut does not know why Ingrid is buying euros at his offer price, but he protects himself from further euro sales to someone who may be better informed than he is by raising his offer price. The bid price may be left unchanged because the order was to buy his euros; in such a case the spread increases, with the higher offer price due to the possibility of trading with a better-informed counterparty who wants him to sell euros.

The inventory control and asymmetric information effects can help explain why exchange rates change throughout the day, even in the absence of news regarding the fundamental determinants of exchange rates. The act of trading generates price changes among risk-averse traders who seek to manage their inventory positions to limit their exposure to surprising exchange rate changes and limit the potential loss from trading with better-informed individuals.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780128041062000010

Other Financial Derivatives

George Levy George Levy , in Computational Finance Using C and C# (Second Edition), 2016

7.3.1 FX Forward

A foreign exchange (FX) forward is a contract to exchange a given amount of domestic currency for an agreed amount of foreign currency at a future time $T$ . If $P^{f}$ is the amount (number of units) of foreign currency, and $P^{d}$ is the amount (number of units) of domestic currency, then the value (in domestic currency) of the FX contract at time $T$ is

$F X_{d} (T) = P^{f} X_{d}^{f} (T) - P^{d} .$

The value of the contract at time $t$ is thus

$F X_{d} (t) = {P^{f} X_{d}^{f} (t, T) - P^{d}} D F^{d} (t, T),$

where $t < T$ . Substituting for $X_{d}^{f} (t, T)$ from equation (7.3.1) then gives

$F X_{d} (t) = {P^{f} X_{d}^{f} (t) \frac{D F^{f} (t, T)}{D F^{d} (t, T)} - P^{d}} D F^{d} (t, T),$

which can be re-expressed as

(7.3.2) $F X_{d} (t) = P^{f} X_{d}^{f} (t) D F^{f} (t, T) - P^{d} D F^{d} (t, T) .$

The value of this FX Forward contract in base currency is thus

$F X_{b} (t) = {P^{f} X_{d}^{f} (t) D F^{f} (t, T) - P^{d} D F^{d} (t, T)} X_{b}^{d},$

that is,

(7.3.3) $F X_{b} (t) = P^{f} X_{b}^{f} (t) D F^{f} (t, T) - P^{d} D F^{d} (t, T) X_{b}^{d} (t),$

where we have used the fact that $X_{d}^{f} (t) X_{b}^{d} (t) = X_{b}^{f} (t)$ .

An alternative way of expressing equation (7.3.3) is as

(7.3.4) $F X_{b} (t) = P^{f} {X_{b}^{f} (t) D F^{f} (t, T) - K D F^{d} (t, T) X_{b}^{d} (t)},$

where $K = P^{d} ∕ P^{f}$ . In the next section, we will see that $K$ , the agreed rate to be paid for one unit of foreign currency in units of domestic currency, corresponds to the strike of an FX call option.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B9780128035795000140

Exchange Rates, Interest Rates, and Interest Parity

Michael Melvin , Stefan Norrbin , in International Money and Finance (Ninth Edition), 2017

Deviations From Covered Interest Rate Parity

Even though foreign exchange traders quote forward rates based on interest differentials and current spot rates so that the forward rate will yield a forward premium equal to the interest differential, we may ask: How well does interest rate parity hold in the real world? Since deviations from interest rate parity would seem to present profitable arbitrage opportunities, we would expect profit-seeking arbitragers to eliminate any deviations. Still, careful studies of the data indicate that small deviations from interest rate parity do occur. There are several reasons why interest rate parity may not hold exactly, and yet we can earn no arbitrage profits from the situation. The most obvious reason is the transactions cost between markets. Because buying and selling foreign exchange and international securities involves a cost for each transaction, there may exist deviations from interest rate parity that are equal to, or smaller than, these transaction costs. In this case, speculators cannot profit from the deviations, since the price of buying and selling in the market would wipe out any apparent gain. Studies indicate that for comparable financial assets that differ only in terms of currency of denomination (e.g., dollar- and pound-denominated Eurodeposits in a German bank), 100% of the deviations from interest rate parity can be accounted for by transaction costs.

Besides transaction costs, there are other reasons why interest rate parity may not hold perfectly. One other reason, for small deviations from interest rate parity, is the potential difference in taxation of interest earnings and foreign exchange rate earnings. If these are differently taxed in a country then the effective return Eq. (6.4) might not hold since one side involves only interest earnings and the other interest earnings and foreign exchange earnings. Thus it may be misleading to simply consider pretax effective returns to decide if profitable arbitrage is possible.

Two more reasons for why interest rate parity might not hold perfectly are government controls and political risk. If government controls on financial capital flows exist, then an effective barrier between national markets is in place. If an individual cannot freely buy or sell the currency or securities of a country, then the free market forces that work in response to effective return differentials will not function. Indeed, even the threat of controls could affect the interest rate parity condition. Political risk is often mentioned in conjunction with government controls. The interest rate parity condition is not directly affected by political risk, such as a regime change. Instead it is the threat of the new regime imposing capital controls that affects the interest rate parity condition. We should note, however, that the external or Eurocurrency market often serves as a means of avoiding political risk, since an individual can borrow and lend foreign currencies outside the home country of each currency. For instance, the Eurodollar market provides a market for US dollar loans and deposits in major financial centers outside the United States, thereby avoiding any risk associated with US government actions.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B978012804106200006X

Options Engineering with Applications

Robert L. Kosowski , Salih N. Neftci , in Principles of Financial Engineering (Third Edition), 2015

11.2.3 Risk Reversals

A more advanced version of the synthetic long and short futures positions is known as risk reversals. These are liquid synthetics especially in the foreign exchange markets, where they are traded as a commodity. Risk reversals are directional positions but differ in more than one way from synthetic long–short futures positions discussed in the previous section.

The idea is again to buy and sell calls and puts in order to replicate long and short futures positions—but this time using options with different strike prices. Figure 11.7 shows an example. The underlying is S _t. The strategy involves a short put struck at K ₁, and a long call with strike K ₂. Both options are out-of-the-money initially, and the S _t satisfies

(11.13) $K_{1} < S_{t} < K_{2}$

Since strikes can be chosen such that the put and call have the same premium, the risk reversal can be constructed so as to have zero initial price.

By adding vertically the option payoffs in the top portion of Figure 11.7, we obtain the expiration payoff shown at the bottom of the figure. If, at expiration, S _T is between K ₁ and K ₂, the strategy has zero payoff. If, at expiration, S _T<K ₁, the risk reversal loses money, but under K ₂<S _T, it makes money. Clearly, what we have here is similar to a long position but the position is neutral for small movements in the underlying starting from S _t. If taken naked, such a position would imply a bullish view on S _t.

We consider an example from foreign exchange (FX) markets where risk reversals are traded as commodities.

Example

Twenty-five delta 1-month risk reversals showed a stronger bias in favor of euro calls (dollar puts) in the last 2 weeks after the euro started to strengthen against the greenback.

Traders said market makers in EUR calls were buying risk reversals expecting further euro upside. The 1-month risk reversal jumped to 0.91 in favor of euro calls Wednesday from 0.3 3 weeks ago. Implied volatility spiked across the board. One-month volatility was 13.1% Wednesday from 11.78% 3 weeks ago as the euro appreciated to USD1.0215 from USD1.0181 in the spot market.

The 25-delta risk reversals mentioned in this reading are shown in Figure 11.8. The risk reversal is constructed using two options, a call and a put. Both options are out-of-the-money and have a "current" delta of 0.25. According to the reading, the 25-delta EUR call is more expensive than the 25-delta EUR put.

11.2.3.1 Uses of risk reversals

Risk reversals can be used as "cheap" hedging instruments. Here is an example.

Example

A travel company in Paris last week entered a zero-cost risk reversal to hedge US dollar exposure to the USD. The company needs to buy dollars to pay suppliers in the United States, China, Indonesia, and South America.

The head of treasury said it bought dollar calls and sold dollar puts in the transaction to hedge 30% of its USD200–300 million dollar exposure versus the USD. The American-style options can be exercised between November and May.

The company entered a risk reversal rather than buying a dollar call outright because it was cheaper. The head of treasury said the rest of its exposure is hedged using different strategies, such as buying options outright. (Based on an article in Derivatives Week (now part of GlobalCapital).)

Here we have a corporation that has EUR receivables from tourists going abroad but needs to make payments to foreigners in dollars. Euros are received at time t, and dollars will be paid at some future date T, with t<T. The risk reversal is put together as a zero-cost structure, which means that the premium collected from selling the put (on the USD) is equal to the call premium on the USD. For small movements in the exchange rate, the position is neutral, but for large movements it represents a hedge similar to a futures contract.

Of course, such a position could also be taken in the futures market. But one important advantage of the risk reversal is that it is "composed" of options, and hence involves, in general, no daily mark-to-market adjustments.

Read full chapter

URL:

https://www.sciencedirect.com/science/article/pii/B978012386968500011X