Foreign Exchange After EMU, Part II

In the new foreign exchange world, exotic barrier options move the vanilla markets, which move the cash. What kind of a market is this?

By Andrew Webb

Thrust that you’re so proud of? Ancient history to the guys in foreign exchange options.

These days, however, there are signs of a change in the way the over-the-counter foreign exchange derivatives market is evolving. Innovation is now incremental rather than explosive, with many new products consisting of existing derivatives cloth being cut to a different pattern, rather than being newly built structures from the ground up. In the vast majority of cases, the new tweaks are being applied to barrier structures, which are now so well-understood and commonly traded that asking for something a little à la carte in this area no longer involves paying over the odds. Rather like a mix-’n’-match candy counter, major dealers can now price most of the variants anyone is likely to come up with on the fly. This almost blasé approach to what was once considered the cutting edge of derivatives has even thrown up the serious possibility of direct retail participation in foreign exchange exotics via Internet trading links.

But the sheer size and flexibility of the foreign exchange exotics market, particularly in barrier products, has been having another effect as well. It used to be a popular gripe of the hidebound that derivatives activity caused distortions in the cash market—the tail in effect wagging the dog. That’s now moved a step further, with barriers (especially when clustered at particular spot levels) wagging the vanilla market puppy, which in turn wags the cash market dog.

Elsewhere, volatility products have become increasingly active, with this year’s trendy product, the volatility swap, hogging much of the limelight, although volatility forwards have also been active. While the products used have generally been of a more conventional nature, volatility-related trades have also been a big feature in derivatives activity relating to pegged currencies, such as the Hong Kong dollar.

Barriers

As the structure that largely kickstarted the growth in foreign exchange options, the barrier has become a basic ingredient in a huge number of products. A fairly recent variant has been windowed/partial barriers with knockout levels that can appear or disappear. Apart from a reduction in premium (in some cases), one of the big attractions here is the ability to fine-tune the structure to accommodate specific events or scenarios. For example, an option buyer might be looking to pick up a sterling $1.65 call with a knockout at $1.60, but is concerned that spot might well trade through that level in the next couple of weeks. The solution? A windowed barrier where the barrier will not come into existence for the next fortnight. “We’re definitely seeing more requests for these, mostly in the major crosses such as euro/U.S. dollar, but we’ve also seen some activity in sterling and Swiss franc,” says Adam Kreysar, cohead of foreign exchange derivatives at Warburg Dillon Read in New York.

Foreign Exchange Goes On-Line

Just as in other areas of the securities markets, on-line trading is making its presence felt in foreign exchange derivatives. Over the last three or four years, most of the technology-smart banks have been moving in this direction. On the one hand, operations such as Warburg Dillon Read have been offering exotics embedded in other structures to its on-line investors. On the other, custodians such as Chase have been offering basic on-line foreign exchange trading for their custodial clients of five years now and have since moved into on-line margin-trading. “At some point, somebody lit a match and realized they could put all this together, so banks offering on-line trading will try to push up their product mix into more sophisticated areas,” says Julian Cook, foreign exchange options product manager at FNX Software. “A lot of banks we have talked to in the last year are moving in this direction, although the challenge will be to push out all the exotic structuring into some kind of electronic trading arena.” (For example, although the bulk of vanilla interbank option deals are done through Reuters’ Dealing network, more-exotic products haven’t made it onto the matching networks because of the difficulties inherent in reading the conversations or structuring the deals.) Some even see more esoteric foreign exchange products such as “spot trader” options moving in this on-line direction, even to the extent of retail participation. These allow the buyer to trade spot foreign exchange up to a maximum position size as often as desired during the life of the option. If, at option expiry, the results from the trading activity are positive, the option buyer keeps the profit; if they aren’t, the option seller picks up the tab. Although these options have been primarily aimed at proprietary accounts, or for those desks wishing to give junior traders realistic match practice with limited risk, Craig Puffenberger, global head of foreign exchange options at CSFB, notes that there is also retail activity. “Although, as yet, such activity in these products has come from large individual investors who already regularly trade the spot market, subject to certain constraints there’s no reason why they couldn’t have a broader audience via on-line distribution for both the option and its associated foreign exchange trading component,” he says. “In principle, I’d welcome on-line interest from smaller accounts in this sort of product.” —A.W.

Although long a commodity product in major crosses, barriers have also recently been extending their remit in emerging markets as well. After last year, 1999 was seen as a transition year, and many traders now expect to see at least some windowed/partial barriers in exotic currencies during 2000. This year, double no-touches have been gaining in popularity as a convenient tool for going short volatility in emerging markets, without taking too much risk. Mid-1998 saw quite a few double no-touch U.S. dollar/rand trades for proprietary positions going through the market in reasonable size, since volatility was historically high at 27 percent to 30 percent. Since then, however, liquidity has fallen back on these, with wide prices being made as the market waits for vanilla products to catch up and provide a better hedging medium.

How to Exploit a Currency Anomaly

A particular growth area in foreign exchange derivatives since the start of the year has been trades that seek to exploit or hedge against the anomalies surrounding currencies that are pegged to a specific exchange rate, rather than freely floating. Favorites here have been Hong Kong, Argentina and Poland. “Argentina in particular has seen a lot of structured deals of this type—especially in non-deliverable forwards (NDFs) and options,” says Nigel Babbage, global head of foreign exchange derivatives at Paribas, based in New York. Pricing Argentine options has proved something of a challenge since the spot rate is fixed, so the market has had to calculate volatility rates from the way the NDFs trade instead. Nevertheless, demand has been brisk, driven at least in part by the large number of major U.S. and European corporates with substantial exposures to Argentina that have needed to hedge against a possible devaluation. “We aren’t necessarily seeing completely new products being built to take advantage of these pegged scenarios,” says Tim Owens, managing director in charge of risk advisory at Chase in London. “It’s more a case of making innovative use of existing products to build structures that can exploit the deficiencies or fine detail of how the mechanisms behave.” In some cases, comparatively simple derivatives methods are the most effective. For example, the Hong Kong dollar is being devalued vs. the U.S. dollar at a “crawl rate” of one pip per working day, a process that will cease when it reaches 7.80 Hong Kong dollars. This process often results in an official central rate that prices the Hong Kong dollar several hundred pips stronger than the spot rate implied by discounting the forward market. As a result, one of the most popular trades has been to sell at-the-money U.S. dollar forward puts to exploit this anomaly. The effect of this has been, effectively, to place an unofficial cap on U.S. dollar/Hong Kong dollar volatility, because as soon as implied volatility on the U.S. dollar forward puts reaches an attractive level, sellers step into the market. A similar situation, but with a slightly different twist, applies to the Polish zloty, which, since the beginning of the year, has been pegged to a basket comprising the U.S. dollar (45 percent) and the euro (55 percent). Calculating the U.S. dollar/zloty exchange rate takes into account this currency basket and a crawling peg, which (although the details are confidential) amounted to a monthly devaluation of 0.3 percent per month in the first quarter of 1999. In addition, the zloty is allowed to fluctuate +/- 15 percent around the central parity calculated by this method. The net result has been an increasing use of basket options to exploit the zloty’s strength or weakness relative to its basket peg. One popular trade, in order to reduce premium costs, has been for options to pay off a fixed amount for every point the zloty moves above or below a fixed percentage level of strength or weakness relative to the basket. Accurate valuation of foreign exchange derivatives under such constrained circumstances is understandably more than a little problematic. “You basically have to throw out all the normal distribution assumptions and start from there,” says Craig Puffenberger, global head of foreign exchange options at CSFB in New York. “You need to have your own clear view of the distribution, because it’s not something you can obtain from the market, which is inefficient or not well-defined.” Coming up with a reasonable valuation also involves such factors as comparing the relative costs of an option and a forward, testing probabilities with historical data and (if appropriate) referring to the “crawl calendar.” There’s been quite a variation in the quality of pricing under these circumstances with several of the less-diligent players believed to have burned their fingers, especially in the zloty and Hong Kong dollar, since the beginning of the year. By contrast, the more cautious participants will typically use an arsenal of three or four different models or methodologies to derive a consensus valuation./font> Puffenberger points to another important factor in this somewhat inexact science. “In a commodity market such as U.S. dollar/euro, your own research is unlikely to make as much difference in pricing as your in-house research on, say, Hong Kong or Argentina, which could be quite different compared with your competition’s research,” he says. —A.W.

There’s a flip side to this activity in the major crosses. While buying reverse knockouts remains largely the domain of buy-side punters looking for minimum premium outlay and maximum leverage, many major dealers now make extensive use of the liquidity in standard knockouts as a hedging tool for their activity in vanilla products—yen/U.S. dollar, euro/U.S. dollar and cable being especially popular. This has been a major factor in the rise in standard knockout volume this year—together with a commensurate fall in margins.

The rationalization of products

While volumes in “straight” barrier products have continued to balloon, the weird and wacky have to a large extent fallen by the wayside. “Exotics are less diverse than a couple of years ago,” says one OTC foreign exchange options dealer at a French bank. “People these days prefer things like no-touches because they are easy to understand—‘stay in this range for three months and we’ll give you odds of eight to one.’ In other words, they like a straight bet.”

“The ability to take an outright volatility position without administrative overhead has made volatility swaps quite popular this year.” —Tim Owens Chase

Until a couple of years ago, there was considerable activity in more complex products, including multiple knockouts in different currencies. The shift back to the basics, such as straight knockouts, knock-ins and double no-touches, has translated into better liquidity and far bigger lot sizes. Until about a year ago, the standard size for a double no-touch in a major cross was $1 million, with $2 million to $3 million considered tricky to handle. Now $10 million to $20 million is relatively commonplace, with at least one $30 million in U.S. dollar/yen knockouts being traded last August.

An adjunct to this greater liquidity and rationalization has been improved flexibility. Not only is the sell-side able to structure bespoke products more quickly from standard components, but the buy-side is much clearer in its expectations. “Three or four years ago, people were just as likely to put on weak as strong structures; now they’re looking to put on strong structures and leverage things up to their advantage,” says Craig Puffenberger, global head of foreign exchange options at Credit Suisse First Boston in New York. “If they don’t want to pay for a particular part of the distribution for a currency pair, they can chop it off with a knockout and use the premium saved to leverage up the juicy part of the trade they want.”

The barrier effects

Depending on your perspective, improved liquidity and flexibility cut both ways, especially in the case of barrier structures. Their discontinuous payoff function, combined with the large amount of vanilla activity required to hedge them effectively, often causes eccentric behavior in both vanilla derivatives and the spot market. For example, selling a $100 million barrier option might necessitate trading $500 million or $600 million in the vanilla market to hedge it. If the option knocks out, the hedge has to be unwound in a hurry.

“Unless clients have a specific reason for having a barrier at a popular level, we recommend avoiding it.” —Craig Puffenberger Credit Suisse First Boston

In the case of products such as reverse knockouts (see “What’s Exotic?” July), this eccentric behavior can easily become exaggerated. One of the reasons that back-end U.S. dollar/yen has been so volatile this year has been the extremely high sensitivity to volatility of these products. As a result, when volatility levels started rising, market-makers became shorter and shorter of volatility. Having already sold volatility to hedge, as levels rose they became caught in a vicious spiral since they had to keep buying it at ever-higher levels to balance their positions. The net effect was dramatic, with one-year U.S. dollar/yen volatility rising from 13 percent to 17 percent in about six trading sessions (previously unheard of), and afterward falling back to around 14 percent. “That sort of volatility whip leaves scars,” says a trader at one U.S. bank. “A leather thong offers no protection.”

Clustering of barriers at popular price points can exaggerate this effect still further, especially if the barrier knocks out. Then there’s real excitement, since the whole dealer community has to rush for the exit at the same time to dump their now superfluous vanilla hedges. Such clustered barriers are vulnerable to being “run” in just the same way as clustered stop losses are in any market. “Unless clients have a specific reason for having a barrier at a popular level, we recommend avoiding it,” says CSFB’s Puffenberger. “Apart from anything else, we can make a better price if we can avoid the most popular levels.”

“The challenge will be to push out all the exotic structuring into some kind of electronic trading arena.” —Julian Cook FNX Software

Finally, there are signs that the effect of barriers on the spot market has even permeated the thinking of central bankers. Late spring and early summer of this year saw a continual buildup of various U.S. dollar/yen barrier option positions with triggers set at 108. As the yen continued to climb, it became increasingly likely that the Bank of Japan would intervene, but it also became increasingly apparent that it wasn’t going to waste its gunpowder either. The BoJ sat carefully on the sidelines waiting for the barriers at 108 to blow up before stepping into the market to intervene—albeit unsuccessfully.

Vol Swaps and Forwards Turn Vanilla

Although volatility derivatives have been touted as the flavor of the month in a variety of underlying markets, their impact in foreign exchange has been considerable. “The number of people now looking at volatility as an asset class in its own right has definitely increased,” says Adam Kreysar, cohead of foreign exchange derivatives at Warburg Dillon Read in New York. “As a result, volumes in volatility derivatives based on foreign exchange have continued to rise.” The ubiquitous volatility swap has been a prominent feature among the major currencies. They are most easily envisaged as the equivalent of a sequence of straddles that are permanently at the money. Counterparties agree to buy or sell volatility at a specific volatility level over a fixed period, with positions typically being marked to market on a daily basis throughout that period. Payoff is usually on the basis of a currency amount per percentage point above or below the volatility strike level at maturity. The big advantage for those outside the dealer community is the ability to use volatility swaps for taking a clean bet on the direction of volatility in a particular currency. So far, the only way to do this has been by combining vanilla options to obtain the desired profile. The big downside to this was the sheer administrative hassle of having to rebalance positions continually to maintain delta neutrality as the market moved. “That ability to take an outright volatility position without incurring the substantial administrative overhead associated with delta hedging has meant that volatility swaps and volatility forwards have been quite popular this year,” says Tim Owens, managing director in charage of risk advisory at Chase in London. Originally regarded as something likely to appeal only to hedge funds, the penetration of volatility swaps is now much broader, with conventional fund managers also taking an interest. In the interbank market, the most active currency (exotically speaking) has been the yen. Its merits as a speculative currency have resulted in a fair amount of activity from conventional fund managers in one-year yen volatility swaps. Some even see volatility swaps becoming commonplace. “Volatility swaps are getting close to being an everyday product. Especially in currencies such as the yen where there is good liquidity, you often see them embedded in warrants,” says the head of foreign exchange options at a major German bank. “Documentation is now fairly uniform, which has also helped.” Apart from volatility swaps, the foreign exchange market has also seen substantial activity in volatility forwards. This has in large part been a result of their suitability as a vehicle for European monetary union convergence trades. (A popular strategy in the first quarter this year, for example, was selling sterling two-year volatility one year forward.) Although not a new product, the volume has started to pick up as an increasing number of players look for the means to exploit changes in the shape of a currency’s volatility curve. As with volatility swaps, another big attraction has been the opportunity to avoid the administrative hassle of continually readjusting straddles. —A.W.

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