This article examines financial engineering techniques and combined derivative products in terms of their uses in the wider derivatives markets.
What is Financial Engineering?
Financial engineering refers to the development of pricing methodologies and hedging techniques underlying financial derivative products.
One aspect that leverages the power of derivative products in a simple, elegant fashion is the combination of existing derivative products. Let’s consider a few of these different combination products that can contain vanilla products, exotic products, products from different asset classes, etc. For simplicity’s sake, all of the following examples will use foreign exchange as the asset class. It is just as easy to extend this to equities, fixed income, or commodities. The actual strikes involved are contrived in order to demonstrate the behavioral characteristics of the products in question.
Aspects and Examples of Financial Engineering
Let’s consider an example in which spot USD/JPY (i.e. the number of Japanese Yen per 1 US dollar) is at 115. The month is February. Through analysis, we have come to believe that spot USD/JPY is ready for a breakout in the month of April, following the Japanese fiscal year-end. Or, at least, spot USD/JPY could be in for some real volatility. This is predicated on the view that Japanese corporations and investors, having placed money offshore to take advantage of better investment opportunities abroad, will repatriate these funds for fiscal year-end only to send them offshore again after closing the books. We also know that the US trade representative is conducting a review of improvements to Japanese trading practices and that she will present this report to Congress in early March. This report is likely to highlight tensions relating to the burgeoning US trade imbalance with Japan (and the rest of the world).
Spot USD/JPY could follow a roller-coaster over the next few months; going much lower before going much higher. If we buy an at-the-money-spot 115 USD Call/Japanese Yen Put and we simultaneously buy an at-the-money-spot 115 USD Put/Japanese Yen Call on the same notional amount of $10 million US dollars and for the same expiry date of May 1, we have purchased a straddle on the USD/JPY.
Instead of purchasing options with the same expiry date, notional amount and strike, we could have varied the financial engineering strategy by buying two “out-of-the-money” options. For example, we could have purchased simultaneously a May 1st 130 USD Call/JPY Put and a May 1st 100 USD Put/JPY Call. Compared to the straddle, this strategy is cheaper, although we have to be careful when we are hedging the delta around the expiry so that we are not left with a cash position that is unlikely to make money. For example, let us suppose that at expiry, spot is at 122 and from our delta hedging activities we are short US dollars against Japanese Yen. We must be sure to close out this position as soon as the options are expired if we do not have a firm view that the US dollar will weaken.
The Risk Reversal
Consider now that a corporation is using financial engineering and hedging its exposure to a move higher in the US dollar against the Euro. Spot EUR/USD (i.e. the number of US dollars per 1 unit of the Euro) is quoted at $1.1335. The corporation has a firm commitment to buy a factory in Germany in three months’ time that will cost them Euro 10 Million. They are exposed to fluctuations in the EUR/USD exchange rate because they are a US-based company reporting their profits in US dollars.
The first hedge that comes to mind is the outright forward. They could buy Euros against US dollars for delivery on the same date that they need to make the payment from their account for a rate of $1.1294. However, they think that there is a possibility that the European Central Bank will not lower interest rates for at least six months, and so the Euro could drift higher against the US dollar.
Therefore, they enter into a risk reversal. They buy an “out-of-the-money” Euro call/USD put with a strike of $1.15 against selling an “out-of-the-money” Euro Put/USD Call with a strike of $1.11 for zero cost. How does this work at expiry? If spot settles above $1.15, the corporation will exercise their Euro call and buy Euros at $1.15. If spot settles below $1.11, they will be exercised on their Euro put and they will consequently buy Euros at $1.11. Anywhere in between $1.11 and $1.15 neither option is exercised, with the corporation buying their Euros at the market rate in the spot market. This structure is sometimes called a “range forward” because it enables the corporation to lock in a range within which they know with certainty that they will be buying Euros while giving them the flexibility of gaining from a small movement in their favor in the currency pair.
The Trigger Forward
Consider now a currency pair that is only going in one direction. Take as an example the New Zealand dollar against the US dollar in which the New Zealand dollar is in a constant state of decline.
The simplest strategy might be to sell NZD/USD on a forward outright basis. If spot NZD/USD was at 0.6400 and the forward outright was 0.6362 for six months’ time, that means that holding the period for six months has a funding cost. If spot NZD/USD stayed at 0.6400, the trader would be out 0.0038 points on whatever actual amount they traded. Instead, they could have done the following, taking advantage of nervously high NZD/USD implied volatilities. They could have bought a six-month NZD put/USD call struck at 0.6510 that knocked out if 0.6510 traded before the option expired and simultaneously sold a six-month vanilla NZD call/USD put struck at 0.6510. The combination of the two options would cost nothing at inception. The higher the implied volatilities involved, the higher the strike would be in reference to spot because the trader here is net selling volatility.
The Range Binary
Finally, let us consider the range binary; a financial engineering structure that pays out a lump sum if spot stays within a specific range without trading at either level in exchange for the payment of a relatively small upfront premium. Let’s say that we are looking at USD/CAD (i.e. the number of Canadian dollars per 1 unit of the US dollar). We believe that USD/CAD is stuck in a range between 1.50 and 1.55 for the next two months. How do we take advantage of this view? We could simultaneously purchase a double barrier USD call/CAD put with a strike of 1.50 that knocks out at either 1.50 or 1.55 and a double barrier USD put/CAD call with a strike of 1.55 that knocks out at either 1.50 or 1.55. If spot stays in the range without triggering either 1.50 or 1.55, we will make 0.0500 on the notional amount of the options. The options themselves are relatively cheap because they are so likely to be knocked out. The higher the implied volatility, and the more likely they are to get knocked out, the cheaper these structures.
Financial Engineering Implications
This article has outlined various examples of the way financial engineering techniques and combined derivatives products can be used to manage derivatives investments. While these examples are all hypothetical, they are still important illustrations of the kinds of decisions and investments derivatives professionals are expected to deal with.
– Article by Chand Sooran, Point Frederick Capital Management, LLC