Hedging Multiple Currency Exposures The Easy Way
Corporates with exposures to multiple currencies have a
new solution: let the dealer worry.
By Miriam Bensman
Few problems can be as difficult for corporate treasuries as hedging
exposures in several currencies. Exposures to different currencies often
vary seasonally in total size and mix, and they can include both long and
short dollar positions.
Hedging each exposure separately can be enormously expensive and inefficient. Trying to take advantage of correlations and off-setting positions to cut
premium costs is mathematically complex and, potentially, quite risky. Correlations,
after all, are the trickiest and riskiest inputs into any option model.
It's not surprising that a number of corporates have turned to currency
basket options to manage these complex exposures.
The principle charm is simplicity. "The company dumps its whole
FX risk problem on the dealer, and says, 'You figure it out, and you take
the risk,'" explains Wilson Ervin, managing director for corporate
marketing and structuring at Credit Suisse Financial Products in New York.
"The options are attractive to customers because there's just one option
to keep track of," notes Peter E. Lee, assistant vice president for
currency option trading at ABN AMRO Bank in Chicago.
Cost is also a major selling point. Typically, deals are struck when
a company can cut its premium paid by at least 20 percent versus the cost
of buying a basket of options on each currency exposure. "It's really
a way to capitalize on the natural hedges in your portfolio of exposures,"
says Richard Within, a partner in the J. Aron division of Goldman, Sachs
The trades, while relatively infrequent, are often huge, from $100 million to $1 billion, as treasurers take care of their entire hedging needs for
the year in one stroke. The options usually have terms of a year or less,
to eliminate doubt about whether they can be treated as hedges for accounting
purposes. Companies with contractual flows may go out longer, since basket
hedges on such flows also get hedging accounting.
Perhaps not surprisingly, few corporations are willing to talk about
an instrument that they use to cover most of their currency exposure. Dealers
say that Gillette and Colgate-Palmolive have used them in the past, but
neither was willing to comment.
Old and New
Currency basket options come in two principal types. Long-only or short-only basket options, which have been around for a decade, are used to cover a
portfolio of 10 different currencies that are all long the dollar, or all
short the dollar. A likely user of long-only baskets would be a pharmaceutical
or petrochemical company that manufactures in one country and sells around
The other type, long/short basket options or spread options, include
both long and short positions. They may combine, for example, a long yen/dollar
position and a short Deutshe mark/dollar position. Likely users of long/short
baskets are automobile, consumer goods and computer companies that manufacture
and sell all over the world. These basket options are a much more recent
phenomenon, in good part because their complex analytics require enormous
processing power. Dealers say that new PCs allow them to price the complex
transactions quickly enough to bid for trades and run timely hedge reports.
Typically, the options are executed by companies that hedge at the corporate, rather than the subsidiary or business unit level, unless a business unit
itself has a wide basket of currency exposures, notes Michael Hedges, director
of the FX group at Deutsche Morgan Grenfell. That eliminates many potential
candidates, since aggregating risk for hedging requires a sophisticated
risk management system and an accounting system to keep track of which unit
made how much.
Nonetheless, many big multinationals are looking into these options.
"There's nothing to prevent them loading in every currency they use,"
notes Julian Cook, product designer at Inventure, a financial software company.
These options tend to be done by corporates that know what they are doing
and sold by the FX salesman who do."
The economics of the options are conceptually simple, notes Mark Garman, president of Financial Engineering Associates, which last year released
its SPAV model for pricing average rate, basket and spread options, and
combinations of them. Consider a simple, $100 million portfolio of exposures
to just two currencies-Deutsche mark and yen-spread over 12 months. If the
company hedged each currency flow with put options, it would have a strip
of dollar/Deutsche mark puts and a strip of dollar/yen puts. On one day
last year, the total cost for the two strips together was $7.79 million.
If the company bought one strip of baskets options on the two currencies,
it would pay $4.81 million.
Alternatively, Garman adds, the company could buy an average price option for each currency exposure. That would cost $2.14 million. If it bought
an average rate basket option, however, it would pay only $1.55 million,
less than one-fifth the cost of two separate strips. "Of course, when
you pay more, you get more," says Garman. The two separate strips allow
you to keep the gains on each option, rather than apply them to losses in
other months or the other currency. "But typically the user has exposure
to averages, because they're doing continuous ongoing business. So the average
rate basket option is a better hedge of their actual exposure."
Few baskets involve only two currencies. Most cover between five and
25, and the degree of correlation between them is key to the premium cost
savings. Companies with sizable yen or Australian dollar exposures, along
with European currency exposures, are far more likely to see significant
premium cost savings than companies with European currency exposures. Adding
certain emerging markets currencies-like the Malay-sian ringghit or Indonesian
rupiah-also helps, because they are so highly correlated to the U.S. dollar
that they offset short-dollar positions. "I'd rather have five currencies
that were diversified than 10 Europeans that aren't," says Goldman's
A number of corporates have studied basket options and declined to use
them for a variety of reasons. National Semiconductor, for example, found
that it wouldn't save much from buying basket options, because most of its
exposures are long positions in highly correlated European currencies. At
Unisys Corp., Ugar Gunner, manager of worldwide trading, says that for his
firm, basket options would have provided exact matches on its exposures
and savings of 5 percent to 10 percent, but he decided they were too administratively
cumbersome and hard to mark-to-market.
Dealers who elect to sell the options have to keep track of a complex
set of risks. The main additive risk (relative to a simple option) is the
accuracy of the underlying correlation assumptions and the likelihood that
the correlations will shift. Managing the hedge over time can also be tricky,
and, of course, has to be priced into the option premium. FEA's Garman recommends
that people look at a range of correlation coefficients to see how pricing
will be affected.
In some respects, baskets are more predictable than conventional options. Dmitri Papacostas, head of FX options marketing at Chase Manhattan, notes
that basket options generally have a smaller delta and move more smoothly
than conventional options, because they are based on a large number of currencies.
Chase has done a fair amount of volume in long Deutsche mark, short French
franc basket options.
But other dealers say they find pricing the options a lot easier than
managing the risk. "I've heard about dealers selling basket options
for years," notes ABN AMRO's Lee. "But they just knew how to price
them, not how to risk-manage them. I'm sensing a change now that they're
beginning to take off."
Still, relative to exotics such as binary options and barrier options,
the risk is relatively low. "There is some pretty toxic stuff out there,"
Witten says. "Basket options aren't one of them." At least half
a dozen dealers can price the most complex deals, and at least another dozen
will quote simpler structures. Perhaps as a result, competitive bids are
typically fairly close, especially when volatilities are low, and if necessary,
options are not difficult to unwind.