It's the hottest FX trade of 1996 and will be until the markets become choppy again.

By Barclay Leib

Just when you thought you had mastered the ins and outs of derivatives trading, it always seems that Wall Street comes up with yet another iteration of complexity. In the FX options market this year, one such product that has become increasingly popular is the so-called double-barrier range note, or "range box" trade. Products such as these are so complex that they often end up growing dusty in the closet of gee-whiz ideas loved by the investment bank quants, but seldom actually traded by any right-minded client. In this instance, however, range box trades are the hit of the season, given a relatively calm FX market so far this year.

A range box trade-in simple terms-is when a client buys two options, a put and a call, typically with striking prices already in-the-money. If the spot FX market stays within these two strikes until expiration, the customer will make the entire difference between the two strikes, minus his initial premium. "Box" refers to the fact that the terminal payoff diagram migrates to a flat "table top" at expiration. In other words, it does not matter at maturity just where within the range the market ends up: the payoff will be the same. However, if (and this is a big if) either of the two extremes are so much as touched prior to expiration, both options cease to exist and the initial premium is forfeited. Because the probability of touching one or the other out-strike over a multimonth period can be quite high, the initial premium cost of such a strategy can often be surprisingly low.

Easy bet

It is this low up-front cost with high potential payoffs that has attracted market participants to this product. As one dealer explains, "This is a way to bet on a range without all of the incumbent risks associated with naked short option positions. We are seeing more and more traditional nonleveraged players using double knock-outs to make what are in effect leveraged, but limited, risk trades." Another customer states, "It is easier for me to tell you where a given currency or cross will not be in six months, than to guess within a range where it will be in six days. To get paid a 10-1 or 20-1 return for guessing a longer-term range correctly is very attractive. Even if I get knocked out on a single strategy, if I create a small portfolio of these things, I only need one or two to work to be well ahead."

The range of clients now using double knock-outs includes mutual fund money managers, corporate hedgers (mostly out of Europe), and a number of large hedge funds. The average maturity of the most popular trades is shorter than three months, but as implied volatilities have recently declined, participants have increasingly moved further out on the maturity curve.

Volumes have grown to the point where the average bank is doing several double knock-out deals per day, occasionally for sizes in excess of $500 million. Indeed, the consensus among dealers is that the size of the business has grown so much that the exotic flows are starting to have a noticeable impact on both the level of implied volatility of plain vanilla options and on the manner in which both the FX spot and vanilla FX option markets are behaving. Jean Marie Pons, chief options dealer at Société Générale in New York, explains: "Ten years ago if the spot market started to move toward a significant breakout level, one would have expected the implied volatility of options to increase as expectations increased of more dynamic price movement." Today dealers commonly see range barrier trades with out-strikes struck just beyond the breakout levels. "That means," says Pons, "that as you approach these price levels, dealers will need to sell more and more vanilla options-particularly in the short-dated maturities-to keep themselves properly hedged. One also hears quite regularly of barrier levels being defended which you never heard people talk about even two years ago. So at what previously might have been a critical chart level, price movement can actually become quite sticky and paradoxically volatility may get hammered. If you don't understand the flows in the exotic options, this behavior is contrary to any rational expectation."

Yen knockout

But to really understand the effects Pons is referring to, let's analyze a typical trade from start to finish. Let's assume that a hypothetical money manager named Jim notices that vis-à-vis long-term historical norms, U.S. dollar/yen (USD/JPY) volatility is quite high. He is astute enough to know that other things being equal, the higher the implied volatility of the market, the cheaper a range box trade will be. This is because the possibility of knocking-out increases as volatility increases. Jim also has a view that while the market may be quite choppy within a range, the Bank of Japan will defend the 100 yen level, and Japanese exporters will be aggressive sellers toward the 1993 high of 113.

So he asks his friendly option dealer for a nine-month 100­113 range box which is quoted to him as 0.80 percent of notional value, or $80,000 in premium for a $10 million face position. If Jim buys this box, he will have the right in nine months' time to buys dollars at 100 and simultaneously to resell them at 113, and net a cool ¥130 million or approximately $1.2 million. This would be approximately a 14-1 return on his initial premium investment. However, Jim loses this right and his initial premium if either 100 or 113 is touched prior to expiry. For Jim this trade is very much an all-or-nothing proposition, although he may always decide to resell his box prior to expiry, either at a profit or a loss, depending upon how much time has gone by, where the spot market is, and where implied volatilities are trading.

In point of fact, this is exactly the type of trade and currency pairing most popular in 1996. Says Jacques-Moseri Marlio, options sales specialist at Barclays Bank in London, "The combination of (1) relatively high implied volatilities, (2) a large interest rate differential that made out-strikes down at 100 and 101 carry a high theoretical probability of being touched, and yet (3) a strong market view that the dollar was in fact not going to these levels, really made these trades interesting to people." Adds Marlio, "Dollar/yen boxes were simply a natural in 1996."

Dealer strategy

The dealer, meanwhile, has to hedge away this exposure somehow. Most dealers are armed with sophisticated spreadsheets and use some variation of the principles of exotic options "dynamic replication" most eloquently explained in 1993 in a working paper written by Emanuel Derman, executive director at Goldman Sachs. This procedure typically involves selling strips of vanilla options in varying maturities and amounts out to the exotic option expiry date. The goal is to earn enough time decay on these vanilla options to equal or exceed the total payoff due the client at maturity. The goal is also to create a portfolio of combined positions where the vega and gamma attributes of the portfolio (that is, the dollar impact in shifts in volatility and price) will be relatively neutral over time. If at any time Jim's option strategy does indeed knock-out, the extinction of this liability can then become at least something of a windfall gain to the dealer.

The science of such hedging is far from perfect, however, particularly as one moves toward expiry and toward an out-strike. To follow the example above, at a given level of 112.75 JPY at expiry, Jim is going to be owed $1.2 million by his dealer. At 113.00, just 25 pips higher, he will be owed nothing. "At that point there is no way to hedge this exposure using plain vanilla options or any other strategy," says Christopher Bristiel, vice president at Citibank in New York. "The option has become something akin to toxic waste."

Pushing the edge

Gunning the spot market to get it to trade 113 might, of course, be one alternative. But as shown by the experience of Merrill Lynch and several large hedge funds in 1995-involving a knockout level in Venezuelan bonds-this is sometimes easier said than done. In that instance a number of large hedge funds bought puts that only "appeared," or knocked-in, should a given level in the price of the bonds be touched. After buying the puts, however, the hedge funds then bought large quantities of bonds in such a manner that they hoped to actually cause the knock-in level to be reached. If the trade had worked, the hedge funds would have earned a high coupon on their Venezuelan bonds with no price risk, since their puts would have "appeared" to protect their principle investment. Merrill Lynch, the seller of the knock-in options, had different economic interests and valiantly worked to prevent the knock-in level from being reached. In the end the price of the bonds collapsed without the knock-in level clearly having been breached, and the hedge funds and Merrill Lynch ended up in court.

Market stress

Another danger of these exotic structures would appear to be the potential stress that their existence builds up at given market levels. As stated above, the typical hedge that a dealer might put on against a double-barrier range box would be to sell a plain vanilla straddle. Because this hedge has less negative gamma (or rate of change of its delta with respect to a shift in price) than the gamma of the exotic structure he is hedging, the dealer gets to buy currency as a given currency falls toward an out-strike, or sell currency as it rises towards an out-strike.

To a certain extent this natural hedging activity actually helps contain price swings and mute market volatility-at least initially. What happens if an out-strike is touched, however, is that the dealer must then reverse all of his spot hedges, and this can cause precipitous price movements if enough exotic options exist in the market with the same trigger point. The dealer will also need to unwind all of his vanilla option hedges, and may or may not have an exposure to any change in volatility levels depending upon how astutely he layered his strikes and maturities when originally setting up his vanilla hedge. In addition to selling strips of options, dealers will often try to avoid getting caught short volatility after a knock-out event by engaging in advance in "risk reversal" trades (buying, for example, low-delta currency calls versus selling low-delta currency puts). These risk reversals start off volatility-neutral, but can be structured to get the dealer long volatility at a spot level just when he may need it.

"Yes, the danger of sudden jump movements in the market exists, and unwinding hedges in such an environment can be a dangerous proposition," says Marlio of Barclays, "but these products have been around now for some time, and dealers are getting more sophisticated at hedging them properly. At the end of the day, the strategy either works or it doesn't, and so far, the large majority of these trades seem to be working. My clients are very happy with their box trades, and are doing more everyday. The ratio of plain vanilla business we do versus exotic business has changed dramatically, and I can only see that continuing."

Nassim Taleb, former options trader and author of the forthcoming book on exotic options, Dynamic Hedging, is more nervous about dealer hedging activities. Says Taleb: "Double knock-out options have a nonlinear vega exposure and, as such, are not hedgeable with at-the-money vanilla options that are linear with respect to volatility. In addition, it is always dangerous to hedge a discontinuous payoff instrument with a continuous payoff one. At the barrier, the vega of the first will vanish while that of the second will remain alive and ready to bite. Stories of misspecifications of the risks and inaccurate hedges abound-typically when dealers have to liquidate their inventory of vanilla hedges at adverse prices."

The long-term implications for the market of double knock-out structures clearly remains debatable. But what is not debatable is that both customers and dealers seems to like them. In an FX world many now consider commoditized, this one product still carries a relatively healthy bidoffer spread for the dealer. It is a product which clients can buy with limited risk, but then earn time decay and be synthetically short volatility.

Yes, just when you thought that you had it straight-that long an option meant long volatility-exotic options have turned the lexicon of the business upside down. Many a prudent investor may never have occasion to get involved in these products. But if capturing a 17-1 shot strikes your fancy, your local option banker can offer range box trades that quite regularly pay off at such odds.