liquidity & asymmetric risk, hedging a foreign currency securities · pdf...

Liquidity & Asymmetric Risk, Hedging a Foreign Currency Securities Portfolio

Richard-Mark Dodds, Treasury Solutions, CS Zürich.

Date: June 2009 / Slide 2

Issues to be Resolved

! The World�s Predominant Asset Base is in USD, Master/Feeder Fund Share Classes and Fixed Income Portfolios need to be hedged back into Local Currency. (At the 2007 CS Lucerne Conference we spoke about the Optimal Hedging Ratio for a Foreign Currency Bond Portfolio � Appendix 1).

! Typically, Investment Managers FX Hedge with rolling 3 Month FXForwards.

! The $ appreciated 22% vs the EUR in Q3/Q4 2008 at one point after an 8 year decline (0.8231 to 1.6038) which had been significant but gradual.

! FX Hedging of a USD Portfolio, only creates negative Cash Flow issues when the $ appreciates.


Scope of the Analysis - last 5 Years of EUR/$


Issues to be Resolved

! Delta One FX Forward Hedging creates uncertain Liquidity Requirements, which conflict with Financial Planning and the underlying requirement of the Investment Funds to remain Fully Invested

! Intra Quarter Negative FX Mark to Market movements also potentially create Credit Line Issues with Counterparty Banks

! Any alternative to FX Forwards typically involves Options !


What is an Option ?

! Wikipedia; An option is a contract between a buyer and a seller that givesthe buyer the right�but not the obligation�to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for grantingthe option, the seller collects a payment (the premium) from the buyer. A calloption gives the buyer the right to buy the underlying asset; a put option givesthe buyer of the option the right to sell the underlying asset.

! It is typically an OTC Product, just like an FX Forward, Basic and Simple.

! You don�t need to hold it in a Securities Deposit Account, at your Custodian.

! Think of an Option as buying Insurance.

http://en.wikipedia.org/wiki/Underlying


The Value of an Option is determined by;

! The Value of an Option principally depends on; � The remaining Time Duration

� The level of FX Spot

� The level of % Volatility.

! Example of a Dec 2009 Option bought for 5.8%

i.e Spot has moved 3% against the Option Strike (Out of the Money)3 Months of Time Value has elapsed (it is 3 Months later)Volatility has increased 3%- the Option can still be sold for 3.8% !! Remember shorter options are proportionately more expensive and valuable.


Additional Facts about Options

!Provides an Asymmetric Hedge, with the ability to add Alpha, IF the USDappreciates by more than the value of the Option Premium.

!Best Case is that you lock in the Alpha generated (as opposed to just rolling over the FX Forward Gains, into Losses), Worst Case; your Maximum Loss is the Option Premium.

!The Option Premium can be scheduled to be paid Monthly, Quarterly or Annually in arrears.

!Monthly Fund NAV adjustments would be accommodated by simply increasing or reducing the FX Option Amount on the final Forward Option Expiry Date.

FX Share Class Hedging with 12 Month Options


Why 12 Month Options ? � Mean Reversion

! Mean Reversion is a mathematical methodology commonly usedfor stock investing, but it can be applied to other processes. In general terms the idea is that both a stock's high and low prices aretemporary, and that a stock's price will tend to have an average priceover time.

!Rolling a 3 Month ATM Forward EUR Call Option for 12 months Costs circa 2.9%(X4) = 11.6%.

! Single 12 Month ATM Forward EUR Call Option Costs just 5.8%, by comparison � HALF PRICE !


Hedging with 12 Month Options - 5 Year Analysis 2004-2008

! Detailed Analysis for the last 5 years in EUR/$, $3.2 bn Notional Portfolio

! Shows an UNHEDGED total FX loss over the 5 Year period of EUR �(270) mio

Rolling FX Hedge Notional in USD 3'200 5 Year Core Data MatrixForward Allocation 100% 3'200 Forward USD AllocationOption Allocation 100% 3'200 Option USD Allocation

Data EUR/USD Vols 12M Forward 12M Option Prices Forward Expiry Spot at ExpirySpot to Spot (EUR)

Jan-04 1.2599 11.30% -0.0105 4.50% 1.2494 Jan-05 1.3495 -168.64Jan-05 1.3495 10.45% 0.0097 4.20% 1.3592 Jan-06 1.1963 303.78Jan-06 1.1963 9.50% 0.0234 3.80% 1.2197 Jan-07 1.3278 -264.93Jan-07 1.3278 7.00% 0.0167 2.85% 1.3445 Jan-08 1.4713 -235.07Jan-08 1.4713 8.50% -0.0045 3.45% 1.4668 Jan-09 1.4098 94.80

-270.06


Hedging with 3 Month FX Forwards

! 3 Month Rolling FX Hedges showan offsetting gain of EUR 186 mio

! Loss of EUR (84) mio due to the Forward Points

! Max Quarterly Liquidity Requirement EUR 245 mio ($ 355 mio) from FX Hedge Loss,10%+ Portfolio Value

!The $ depreciated in 12 of the 20 Quarters

100% (3 Month) Forwards

EUR Value Hedged at Forward

EUR Value End Of Period

Difference in EUR in Millions

2'546.19 2'591.72 -45.54 2'597.91 2'632.23 -34.32 2'635.82 2'581.69 54.13 2'582.57 2'371.25 211.32 2'368.90 2'467.23 -98.34 2'461.48 2'669.34 -207.85 2'659.84 2'686.48 -26.64 2'673.57 2'675.03 -1.45 2'661.57 2'646.05 15.52 2'631.63 2'496.78 134.85 2'481.62 2'509.31 -27.69 2'497.18 2'410.09 87.08 2'400.49 2'393.33 7.16 2'384.92 2'349.66 35.26 2'342.72 2'249.80 92.92 2'246.09 2'175.02 71.06 2'173.48 2'052.99 120.49 2'061.75 2'029.68 32.07 2'039.21 2'284.98 -245.77 2'281.79 2'269.75 12.05

186.32


The Solution

!Switch FX Share Class Hedging from 3 Month Delta One FX Forwards to purchasing 12 Month Options, struck at the Forward FX Rate (50% Delta) with Monthly NAV adjustments to the same end date.

!Premiums can be paid (or received for NAV reductions) on T +2 or deferred to the Option Maturity Date.

!Financial Planning is under full control

!Buying Options reduces Counterparty Credit Risk significantly

!12 Month Options are the cheapest to Purchase (vs rolling 1M, 3M & 6M)


The Solution (2)

Using Options historically, your max Liquidity Drawdown Risk has been the max Option Premium of 4.5%*per Year, the actual max realised Liquidity Drawdown was 4.2% in 2005, compared to the actual FX Forward Liquidity Drawdown of more than 10% in Q3, 2008 alone and 14% during 2005.

(*today to enter into this contract would cost circa 5.8% due to higher volatility)

Option Liquidity Matrix

Year Premiums in % EUR

in EUR in Millions

(EUR Hedge Gains - EUR Option Premiums)

2008 3.45 75.00 -75.00 2007 2.85 68.69 136.40 2006 3.80 101.65 111.90 2005 4.20 99.60 -99.60 2004 4.50 114.30 75.70

149.40


The Solution (3)

!In the 5 Year Study Shown (Portfolio $3.2 Bio)

Underlying Portfolio 12 Month Option Hedge FX Forward Hedge 50%/50%

2008 95 (75) (81) (78)

2007 (235) 136 206 171

2006 (265) 112 209 160.5

2005 304 (100) (333) (216.5)

2004 (169) 76 185 130.5

EUR Mio -(270)* 149 186 167.5

* If you are concerned about the relative underperformance of FX hedging due to the InterestRate Differential then you need to consider the successful Knock In Forward Hedging Strategy(Lucerne CS Conference 2007- Appendix Section 2)

A Forward Looking ExampleAsymmetry Benefits


Additional Option vs. Forward Hedge Scenario Comparison

! EUR 100 Mio Underlying Unhedged Fund Value in $, until end 2010

EUR/$ End Dec 2009 End Dec 2010 (-$40 Mio)

(-$20 Mio) 1.75001.5500

1.3500 ($ 135 Mio) 1.3500 (Flat)

1.1500 (+$20 Mio) 0.9500

(+$40 Mio)



! EUR 100 Mio Hedge Via FX Forwards in $, until end 2010

EUR/$ End Dec 2009 End Dec 2010 (FX Fwd 1.3600)* (FX Fwd 1.3700)*

(+$19 Mio)* (+$38 Mio)*

1.5500 1.75001.3500 ($ 135 Mio)

1.35001.1500 (-$21 Mio) 0.9500

(-$42 Mio)

The Cash Gains and Losses are reflected in brackets, they mirror the difference in the

Underlying Unhedged exposure, except for the difference in the Forward Points.



! EUR 100 Mio Hedged Via FX Options in $, until end 2010

EUR/$ End Dec 2009 End Dec 2010 (Option Strike 1.3600) (Option Strike 1.5500)

(+$11.2 Mio) (+$21.3 Mio)

1.5500 1.75001.3500 ($ 135 Mio) �2009 Option Premium EUR 5.8% 1.3500�2010 Option Premium EUR 6.5%

1.1500 0.9500(-$7.8 Mio)* (-$16.7 Mio)**

**Option Premium paid 2009

**Option Premium paid 2009 & 2010 combined



! Underlying Position & Hedge Cash Flow Comparisons

EUR/$ Underlying Fund AssetDifference

1.35 $135 Mio FX Fwd. FX Option Option Vs Fwd.

1.75 -$40 Mio +$38 Mio +$21.3Mio -$16.7Mio*

1.55 -$20 Mio +$19 Mio +$11.2Mio -$7.8Mio*

1.15 +$20 Mio -$21 Mio -$7.8Mio +13.2Mio

0.95 +$40 Mio -$42 Mio -$16.7Mio +25.3Mio

* Includes full cost of Option Premium

! The Option outperforms proportionately more when the $ appreciates, than it underperforms when the $ depreciates


Risks

!With Options, whilst you have managed your Cashflow/Liquidity planning and adjusted your Risk Metrics, should the USD significantly depreciate in every quarter of the year, however unlikely this may be, you will underperform vs the delta one 3 Month FX Forward, by the cost of the Option Premium.

!To minimise the above, we therefore recommend you simply enhance your FX Forward Hedging Strategy by using 50% Options & 50% FX Forwards.


Conclusions!You can optimize your Portfolio Hedging & Liquidity requirements by pursing a

strategy of 50% Options & 50% Forwards. You would balance the fact that the

Option has significant Outperformance with $ appreciation, with less significant

Underperformance in times of $ depreciation and still enhance Liquidity Management.

!You would minimize your potential underperformance to half the Annual Option

Premium.

!Monthly NAV adjustments can be made to the Option Hedge by simply buying or

selling a tranche of the option to the forward Option expiry date just like you would

with an FX Forward.

! Options are much more cost effective with longer maturity dates, you can even sell

an Option if you not longer require it, that is Out of the Money.


Conclusions

! Your Bank can provide you with revaluations from Product Control with a frequency

as required to your Custodian.


Contact Details

! Richard-Mark Dodds a Managing Director at Credit Suisse Corporate & Institutional Treasury ProductSolutions based in Zürich.

! Prior to joining Credit Suisse in 1994, Richard-Mark Dodds worked in the Dow Chemical Corporate Treasury and Price Waterhouse Coopers, following an MBA and BSc in Economics.

! He has extensive knowledge and experience in providing Client Foreign Exchange, Corporate Finance, Legal and Accounting solutions, from working with a variety of teams within Credit Suisse.

! The Team can be contacted on + 41 (0) 44 333 7220 email; [email protected]


Appendix

FX Hedging Strategies for FI Portfolio Managers and Managing FX RiskBernard Possa, Managing Director Head of Global Fixed IncomeRichard-Mark Dodds, Managing Director, Treasury Product Solutions

Swiss Institutional Investors Conference 2007


Currencies - risks and opportunities�

1.45

1.5

1.55

1.6

1.65

1999 2000 2001 2002 2003 2004 2005 2006

CHF/EUR Spot

0.5

0.75

1

1.25

1.5

1.75

2

2.25

2.5

2.75

3

3.25

3.5

3.75

4

1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

CHF/USD Spot

EUR since 1999USD since 1971

2003 � 2006:+11%

1999 � 2002:- 10%

71-78: -58% 79-84: +61% 85-90: -51% 91-98: +7% 02-06: -27%

! Currencies can have large swings both in the short and long term. These can have a big influence on the return of a foreign currency portfolio

Currency hedging helps to reduce/eliminate these risks

! Volatility and especially trends (short and long term ones) offer opportunities

With an active strategy it is possible to generate alpha from these opportunities


Currency returns over time

Currency returns (12 months rolling)

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

Dez98

Dez99

Dez00

Dez01

Dez02

Dez03

Dez04

Dez05

Dez06

over- underperformance LB global agg in CHF rel to SBISource: Ibbotson, own calculations

! The monthly swings due to currency returns can be huge


Higher risk for unhedged currenciesperiod index return p.a. risk p.a.

return minus risk

sharpe ratio

01/99 - 12/06 SBI 3.3% 2.8% 0.5% 0.27LB Global Agg. hedged 3.0% 2.9% 0.1% 0.16LB Global Agg. unhedged 3.2% 6.3% -3.1% 0.11

01/87 - 12/98 SBI 5.6% 3.1% 2.5% 1.00LB US Gvt hedged 5.6% 5.0% 0.6% 0.63LB US Gvt unhedged, in CHF 7.0% 13.5% -6.6% 0.33

01/87 - 12/98 SBI 5.6% 3.1% 2.5% 1.00LB UK Gvt hedged 7.5% 7.0% 0.5% 0.72LB UK Gvt unhedged, in CHF 11.8% 13.2% -1.4% 0.71

01/87 - 12/98 SBI 5.6% 3.1% 2.5% 1.00LB Germny Gvt TR hedged 6.3% 3.4% 2.9% 1.12LB Germny Gvt TR unhedged, in CHF 7.3% 6.1% 1.3% 0.80

SBI = Swiss Bond Index (Pictet General before 10/98), LB = Lehman Brothers

! The risk adjusted return* of unhedged non-CHF bonds is clearly negative, with the exception of the EUR, which is not the case for CHF and hedged non-CHF bonds

! The risk of unhedged non-CHF bonds is in any case significantly higher * Annualised return minus 1 standard deviation


Risk characteristics over time

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

Dez98

Dez99

Dez00

Dez01

Dez02

Dez03

Dez04

Dez05

Dez06

rolling risk global hedged rolling risk SBI rolling risk global unhedged

Quelle: Ibbotson, eigene Berechnungen

Risk (12 months rolling)

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

6.00%

6.50%

7.00%

Dez 03 Dez 04 Dez 05 Dez 06

5y rolling risk global hedged 5y rolling risk SBI 5y rolling risk global unhedged

Risk (5 years rolling)

Source: Ibbotson, Credit Suisse

! CHF and hedged non-CHF bonds exhibit similar stable and low risk properties

! Unhedged non-CHF bonds show a higher risk and changing risk characteristics over time


Currency risk over time

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

Dez 98 Dez 99 Dez 00 Dez 01 Dez 02 Dez 03 Dez 04 Dez 05 Dez 06

risk due to interest rates risk due to currency


! Currency risk is big part of the total risk of an unhedged non-CHF bond portfolio

! Currency risk was on average about twice as high as interest rate risk

Interest rate and currency risk (12 months rolling, absolute)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

IR risk FX risk

Interest rate and currency risk (12 months rolling, in % total)



Correlations over time

! The correlation between CHF and hedged non-CHF bonds is high and stable

! The correlation between CHF (or hedged non-CHF) and unhedged non-CHF bonds is unstable and changes over time

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

Dez98

Dez99

Dez00

Dez01

Dez02

Dez03

Dez04

Dez05

Dez06

rolling corr hedged-SBI rolling corr SBI-unhedged rolling corr hedged-unhedged


Correlations (12 months rolling)



What is the �optimal� hedge ratio?JPM 1+ US Govt Bonds TR in CHF

Jan 2001 - Dez 2005 (5 Jahre)

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Hedge Ratio (Grad der Fremdwährungsabsicherung)

Sha

rpe

Rat

io

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Ren

dite

, R

isik

o in

%

Sharpe Ratio (links)Total Return (rechts)Standardabweichung (rechts)

Jan 2001 - Dec 2005 (5 years)

Sharpe Ratio (left scale)Total return (right scale)Standard deviation (right scale)

Ris

k an

d re

turn

in %

Hedge ratio

Citigroup EMU 1+ Govt Bonds TR in CHF Analysezeitraum Jan 1999 - Dez 2006

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%


Sha

rpe

Rat

io

2.5

3.0

3.5

4.0

4.5

Ren

dite

, R

isik

o in

%


JPM 1+ US Govt Bonds TR in CHF Jan 1996 - Dez 2005 (10 Jahre)

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%


Sha

rpe

Rat

io

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Ren

dite

, R

isik

o in

%


Jan 1996 - Dec 2005 (10 years)


Ris

k an

d re

turn

in %

Hedge ratio

Jan 1999 - Dec 2006 (8 years)


Ris

k an

d re

turn

in %

Hedge ratio

JPM 1+ US Govt Bonds TR in CHF Jan 1986 - Dez 2005 (20 Jahre)

0.00

0.10

0.20

0.30

0.40

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%


Sha

rpe

Rat

io

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Ren

dite

, R

isik

o in

%


Jan 1986 - Dec 2005 (20 years)


Ris

k an

d re

turn

in %

Hedge ratio


Efficient frontier I

! By adding hedged non-CHF exposure to CHF bond portfolio, the risk is reduced. At the same time the return is increased

! The portfolio with the lowest risk would be a mix of 60% hedged non-CHF and 40% CHF bonds

2.9%

3.0%

3.0%

3.1%

3.1%

3.2%

2.6% 2.7% 2.7% 2.8% 2.8% 2.9% 2.9% 3.0% 3.0% 3.1%

risk

retu

rn

100% CHF

100% FW abgesichert

Minimum risk portfolio

100% CHF

100% non-CHF hedged



Efficient frontier II

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50%

risk

retu

rn

100% FW nicht abgesichert


100% CHF


100% CHF

100% non-CHF unhedged

! By adding unhedged non-CHF exposure to a CHF fixed income portfolio the risk can be reduced further

! The portfolio with the lowest risk has 45% CHF, 42% hedged non-CHF and 13% unhedged non-CHF exposure


Characteristics of hedged non-CHF fixed income

! The return� is very similar to a CHF portfolio or even slightly higher� is a lot more stable than an unhedged non-CHF portfolio� is not dominated by the influence of currency returns

! The risk� is a lot lower than in an unhedged non-CHF portfolio� is very similar to the risk of a CHF portfolio or slightly higher� of a pure CHF portfolio is reduced slightly through the addition of hedged non-CHF

exposure

! The correlation with CHF bonds is high and stable! Liquidity is a lot better than in the CHF bond market! The diversification of issuers is a lot better than in the CHF market ! The choice of maturities is a lot higher than in the CHF market


Conclusion

! Bonds are a very important part of every portfolio and this is why an optimal allocation can have an influence on the overall performance

! An investor can expect to be compensated for taking interest rate or credit risk but not for taking currency risk

! Hedged non-CHF bonds are perfectly suited as a substitute and/or as a complement for CHF bonds

! The strategic share of an unhedged non-CHF bond portfolio should be around 15% of the overall fixed income portfolio. A higher share should only be held for tactical purposes

USD/CHF ExposureOptimized FX Hedging with Knock-In Forwards Adding Alpha through enhancedFX Hedging StrategiesAnalysis 2003�2008


Situation

Underlying Long Asset USD 100 mio

Back testing period Jan 2003 - Dec 2008

Jan. 2003 Spot Usd/Chf 1.4010Dec. 2008 Spot Usd/Chf 1.0729

Actual Unhedged FX Loss = 32.8 mio CHFMaximum Mark to Market FX Loss = 43.3 mio CHFSimple FX Forward Hedging Cost 17.5 mio CHFSimple FX Forward only 46% effective hedge


Optimized FX Hedging � Executive Summary

The analysis indicates that during Jan 2003-Dec 2008, the 1 month roll of Zero Premium Knock In Forwards would have been the best performing of the 2 Hedging Solutions analysed.

With an underlying Hedge Notional of $ 100 mio

(Unhedged Loss 32.8 mio CHF)

Simple Forward Hedge Gain of CHF 15.3 mio (imperfect hedge due to forward points)

Knock In Forward Hedge Gain of CHF 35.2 mio

_________________________________________________

Jan 2003-Dec 2008 Alpha added from Knock In Forward vs Vanilla FX Forward= CHF +19.9 mio

Knock In Forward 107% effective hedge


Why Do These Parameters Typically Work Well ?

! 1 Month gives you Flexibility to take advantage of a rise in Market Volatilitydue to event shocks (i.e Hurricanes 2005 / Sept 11, 2001).

! Should you get triggered on a barrier, volatility will likely rise and the next one will be further away, reducing the probability of this happening twice.

! Unlike the FX Forward, you LOCK IN any hedging profits at the end of each month, hence the opportunity for Out Performance.


Important Points to Note + Analytical Information

! Whilst you do not have to follow a calendar month strategy, it is Critical that you maintain a 1 Month period, back testing showed that in 2008 using a 5 Week period would have triggered an additional 3 barriers !

! 1 Month Knock In Forward 2003 - 2008- Information Ratio of 0.4775- Standard Deviation 1.98 mio CHF - Annualized Standard Deviation 6.85 mio CHF


Simple FX Forward

A Simple FX Forward Hedge involves selling the predetermined USD amount at the start of the year, buying CHF and bearing the full cost of the forward points, with then subsequent monthly swaps. There is no flexibility to benefit from a rising USD. The cost of hedging has been typically about 30 CHF pips per month from the higher US interest rates vs Switzerland.

Trade Analysis

STRIKE

Strategy Payout

Disadvantages! No opportunity to

benefit from rising USD

! Pay the full forward points

! Underlying asset may change in value creating hedge mismatch

Advantages" Fixed FX Hedge with

established worst case scenario

Stra

tegy

Pay

off

Usd/Chf

0.95 1.10

Hedge Gain

Hedge Loss


Knock-In Forward

With a Knock-In Forward, you are hedged at all times below the given forward rate, and can benefit in USD appreciation up to a predetermined �Knock-In� level, which is far beyond the Short Call in a Risk Reversal Collar. Should spot USD/CHF never touch the Knock-In level from trade date to maturity and is above the purchased USD Put strike then you will have benefited from a reduction in the hedging costs alone, by not paying the forward points of a simple FX Forward. However, should the spot USD/CHF market trade to the Knock-In level at anytime before the maturity date, you are automatically locked into the predetermined hedge forward rate. We set the Strike of the $ Put, 150 CHF pips below $/CHF spot at the start of each month.

Trade Analysis

STRIKE

Strategy Payout

Disadvantages! Hedge Protection

sometimes worse than FX Forward

! Underlying asset may change in value creating hedge mismatch

Advantages" Zero Premium

" Guaranteed Protection from USD weakness below Put Strike

" Client participates in more USD appreciation to a predetermined level

Participation up to a predetermined level

Stra

tegy

Pay

off

Barrier Knock In

Usd/Chf

0.95 1.10

Hedge Gain

Hedge Loss


Knock- In Forward

Simple FX Forward Hedging under performs over the last 5 years, losing approximately 60% of the Hedging gains in the cost of the forward points due to the interest rate differential.

The combination of a Bought Put and Sold Call Option, AT THE SAME STRIKE, is the same as dealing a forward, so what if we give up something against the outright, maintain a guaranteed hedge, but with the opportunity to do (sometimes) considerably better ?

Product Example in the One Month

($/CHF spot = 1.0100 : 1m swap -0.0002 = 1.0098 outright forward)

Knock In Forward Hedge Rate (guaranteed): 0.9950 (-0.0148 from outright forward)

Knock In Forward Limit / Trigger Rate : 1.0705


Contract Breakdown

Structure (Spot ref. $/CHF 1.0100)

! The contract is made up of two separate options:1. Buy USD Put, strike 0.99502. Sell Up & In USD Call, strike 0.9950, barrier (trigger) 1.0705

! Initially, only option 1 exists. It provides protection at the Hedge Rate of 0.9950

! If the Trigger Rate of 1.0705 is touched, option 2 knocks-in. Together with option 1 it creates a synthetic short forward at the Hedge Rate of 0.9950 (vs. 1.0098 outright forward)


What Happens At Option Maturity ?(1 Month Later)

! $/CHF Spot between 0.9950 and 1.0704 (1.0705 barrier not touched), nothing, neither

counterparty exercises an option.

! $/CHF Spot below 0.9950 (whether 1.0705 barrier touched or not), You as the Client,

exercise the $ Put Option on the bank, the bank exercises nothing. You book the Gain either

by selling the Option at Intrinsic Value (Spot � Strike) or buying $ spot in the market.

! $/CHF Spot above 0.9950, with the barrier at 1.0705 touched. The bank exercises your

Short $ Call Option, you either buy back the Option at Intrinsic Value or buy $ spot in the

market, You book the Loss.

In ALL EXAMPLES you then re-enter into a NEW 1 MONTH ZERO PREMIUM KNOCK IN

FORWARD, exactly the same as before, with strikes 150 Chf below current spot.


Optimized FX Hedging

Risks ?

! In Very Sharp Continuous Linear $ Downtrends and $ Uptrends that the Knock In Forward will Under Perform the simple FX Forward

! The Knock In Forward is an appropriate instrument to use as part of a diversified FX hedging program

! We would recommend 50% Forwards / 50% Knock In Forwards to absolutely limit any theoretically potential underperformance of a hedging program.

Monthly Data Comparative $/CHF FX Strategies Jan 2003 - Dec 2008


Back Testing Detail - P/L CHF by Hedge Strategy 2008Based on $100 mio notional

2008 Implied Volatility

Trend

Low 9.25%

High 24.3%

Spot Underlying (CHF) Forward (CHF) KI Forward (CHF)

Jan-08 1.1220 -4'050'000 3'817'500 2'550'000

Feb-08 1.0815 -3'615'000 3'538'500 2'115'000

Mar-08 1.0454 -3'160'000 3'102'000 1'660'000

Apr-08 1.0138 3'520'000 -3'575'000 0

May-08 1.0490 -820'000 763'161 0

Jun-08 1.0408 -1'500'000 1'457'800 0

Jul-08 1.0258 1'895'000 -1'945'452 0

Aug-08 1.0447 6'610'000 -6'659'400 -8'110'000

Sep-08 1.1108 2'445'000 -2'492'147 0

Oct-08 1.1353 3'179'900 -3'372'400 0

Nov-08 1.1670 4'480'000 -4'537'000 -5'980'000

Dec-08 1.2118 -13'894'900 13'688'448 12'394'900

-4'910'000 3'786'011 4'629'900




Jan-07 1.2247 1'720'000 -2'069'300 0

Feb-07 1.2419 -2'070'000 1'749'500 570'000

Mar-07 1.2212 -300'000 -43'800 0

Apr-07 1.2182 -320'000 -26'000 0

May-07 1.2150 1'710'000 -2'021'694 0

Jun-07 1.2321 -1'620'000 1'305'700 120'000

Jul-07 1.2159 -940'000 634'500 0

Aug-07 1.2065 170'000 -458'226 0

Sep-07 1.2082 -3'765'000 2'756'000 1'610'000

Oct-07 1.1706 -1'080'000 770'000 0

Nov-07 1.1598 -3'700'000 3'450'000 2'200'000

Dec-07 1.1228 -75'000 -1'500'000 0

-10'270'000 4'546'681 4'500'000


Trend

Low 5.3%

High 10.4%




Jan-06 1.3115 -2'550'000 2'107'000 1'050'000

Feb-06 1.2860 1'920'000 -2'311'500 0

Mar-06 1.3052 -1'750'000 1'317'000 250'000

Apr-06 1.2877 -5'570'000 5'126'000 4'070'000

May-06 1.2320 -1'030'000 630'339 0

Jun-06 1.2217 350'000 -761'000 0

Jul-06 1.2252 360'000 -810'500 0

Aug-06 1.2288 10'000 -441'452 0

Sep-06 1.2289 2'200'000 -2'609'500 0

Oct-06 1.2509 -590'000 179'700 0

Nov-06 1.2450 -4'660'000 4'287'147 3'160'000

Dec-06 1.1984 2'630'000 -1'921'000 0

-8'680'000 4'792'234 8'530'000


Trend

Low 6.4%

High 10.5%




Trend

Low 8.5%

High 11.3%


Jan-05 1.1440 5'020'000 -5'200'000 0

Feb-05 1.1942 -3'010'000 2'810'500 1'510'000

Mar-05 1.1641 3'340'000 -3'580'000 0

Apr-05 1.1975 170'000 -400'000 0

May-05 1.1992 5'170'000 -5'430'000 -6'670'000

Jun-05 1.2509 4'320'000 -4'610'000 0

Jul-05 1.2941 -2'170'000 1'880'000 670'000

Aug-05 1.2724 -3'380'000 3'030'000 1'880'000

Sep-05 1.2386 6'530'000 -6'860'000 -8'030'000

Oct-05 1.3039 -1'280'000 930'000 0

Nov-05 1.2911 2'970'000 -3'370'000 0

Dec-05 1.3208 -930'000 540'000 0

16'750'000 -20'259'500 -10'640'000




Jan-04 1.2380 1'580'000 -1'702'000 0

Feb-04 1.2538 4'050'000 -4'171'500 0

Mar-04 1.2943 -540'000 423'790 0

Apr-04 1.2889 -470'000 350'500 0

May-04 1.2842 -3'740'000 3'613'000 2'240'000

Jun-04 1.2468 -1'430'000 1'311'040 0

Jul-04 1.2325 4'700'000 -4'829'000 0

Aug-04 1.2795 -1'100'000 945'000 0

Sep-04 1.2685 -320'000 168'367 0

Oct-04 1.2653 -7'790'000 7'622'500 6'290'000

Nov-04 1.1874 -4'020'000 3'861'067 2'520'000

Dec-04 1.1472 -320'000 132'500 0

-9'400'000 7'725'264 11'050'000


Trend

Low 8.8%

High 12.6%




Jan-03 1.4010 -5'050'000 4'928'000 3'550'000

Feb-03 1.3505 -1'210'000 1'104'500 0

Mar-03 1.3384 4'360'000 -4'473'800 -5'860'000

Apr-03 1.3820 -3'760'000 3'614'650 2'260'000

May-03 1.3444 -3'210'000 3'061'500 1'710'000

Jun-03 1.3123 3'220'000 -3'363'000 0

Jul-03 1.3445 670'000 -796'613 0

Aug-03 1.3512 6'230'000 -6'363'500 -7'730'000

Sep-03 1.4135 -9'420'000 9'294'947 7'920'000

Oct-03 1.3193 4'210'000 -4'340'500 0

Nov-03 1.3614 -7'250'000 7'114'500 5'750'000

Dec-03 1.2889 -5'090'000 4'969'113 3'590'000

-16'300'000 14'749'797 11'190'000


Trend

Low 9.4%

High 11.7%


Accounting Issues - IFRS

! IFRS requires Option Values to be split into Time and Intrinsic Value

! Intrinsic Value is recorded in the Balance Sheet until Maturity

! Time Value is recorded in the Profit and Loss Account

! Calculation is Simply

Option Value (mark to market) � Intrinsic Value = Time Value

Intrinsic Value is simply Strike � Spot reference

i.e Option Value (mark to market) = 3.7%

Current EUR/USD Spot (for mark to market) = 1.2800

You own the 1.2400 EUR Call/USD Put therefore Intrinsic Value = (1.28 � 1.24) = 3.2%

Time Value therefore = 3.7% - 3.2% = 0.5%


Disclaimer

These materials have been provided to you by Credit Suisse ("CS") in connection with an actual or potential mandate or engagement and may not be used or relied upon for any purpose other than as specifically contemplated by a written agreement with CS. In addition, these materials may not be disclosed, in whole or in part, or summarized or otherwise referred to except as agreed in writing by CS. The information used in preparing these materials was obtained from or through you or your representatives or from public sources. CS assumes no responsibility for independent verification of such information and has relied on such information being complete and accurate in all material respects. To the extent such information includes estimates and forecasts of future financial performance (including estimates of potential cost savings and synergies) prepared by or reviewed or discussed with the managements of your company and/or other potential transaction participants or obtained from public sources, we have assumed that such estimates and forecasts have been reasonably prepared on bases reflecting the best currently available estimates and judgments of such managements (or, with respect to estimates and forecasts obtained from public sources, represent reasonable estimates). These materials were designed for use by specific persons familiar with the business and the affairs of your company and CS assumes no obligation to update or otherwise revise these materials. Nothing contained herein should be construed as tax, accounting or legal advice. You (and each of your employees, representatives or other agents) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the transactions contemplated by these materials and all materials of any kind (including opinions or other tax analyses) that are provided to you relating to such tax treatment and structure. For this purpose, the tax treatment of a transaction is the purported or claimed U.S. federal income tax treatment of the transaction and the tax structure of a transaction is any fact that may be relevant to understanding the purported or claimed U.S. federal income tax treatment of the transaction.© 2008 Copyright by CREDIT SUISSE

liquidity & asymmetric risk, hedging a foreign currency securities · pdf...

Documents