The Dollar-Yen Reverse Knock-in Options
Jul 13, 2005
Recently we learnt of a FX options deal that was executed by a large Japanese exporter with a Japanese bank. With the recent strengthening of the Japanese Yen against the US dollar, the Japanese exporter with US receivables entered into a reverse knock-in forward transaction.
The Japanese exporter, with annual turnover of US$500 million (most of it in US Dollar and Euro exports) was caught off guard by the strength in the JPY in the first half of 2004.
The company’s policy in the past few years has been to not hedge its FX risk as it relates to its US receivables. This policy has been effective as the JPY depreciated significantly versus the US dollar form early 2000 onwards until mid-2002. Even though the Japanese currency sharply strengthened in the year 2003 the company has been pretty reluctant to hedge its FX exposure in the options market. The only hedge it did was to buy short term Dollar-yen forward contracts and roll them over. However, given certain research and analyst reports the company believes that the Yen can in fact get significantly stronger and can cross the 100 barrier on the downside.
When the JPY rallied from levels of 110 to a level of 108 sharply in the first half of 2004, the company was mandated by its board of directors to solicit a FX hedging strategy using FX options.
The objective, as far as the Treasurer of the company was concerned, of the FX hedge is to protect the company’s cash flow break-even level of 105 yet allow for upside on a potential weakening of the JPY.
The corporate treasury approached a top tier Japanese bank for an effective hedging solution. While most of economists were calling for continued JPY strength to levels approaching 102 by year-end the Treasurer of the company felt that Yen strength will be capped at around 103-104 level from where there would be a turnaround.
The spot USD-JPY was trading at 108.00 and the company was looking to protect a worst-case rate of 105 and yet allow for participation in US dollar strength.
The Treasurer of the company basically wanted to take advantage of both high-implied volatility in the USD/JPY option market and reasonably generous forward premium.
The company would hedge its US dollar receivable stream for the remainder of fiscal year (2004) and all of the next fiscal year (2005):
- by buying (going long) a series of 12 monthly USD puts/JPY calls at strikes of 105 providing protection on 75% of their US dollar receivables;
- To finance the premium otherwise payable on the JPY calls, the company would sell (write or go short on) USD calls/JPY puts at a strike of 105 with a reverse knock-in at 130.00 on 100% of their US dollar receivables.
The option maturity for both the vanilla calls and the reverse knock-in puts would be one year. The notional amount was in the vicinity of hundred bucks (US$100 million).
The USD calls/JPY puts owned by the bank would only become viable if Dollar-Yen trades at 130.00 during the hedge period. This trigger (knock-in barrier) was much closer to the five year high on Dollar-Yen which was around 134.00.
At each monthly expiry of the vanilla USD put/JPY call, with USD/JPY spot above the 105 strike, and assuming that the 130 trigger (Knock-in barrier) has not traded, the company will be selling its US dollars at the spot rate.
If at any expiry, spot is lower than 105 - say 103 - then the company would exercise its USD put/JPY call option at 105 and would effectively sell their US dollars at 103.
The real risk (scary version) in the above product is that if Japanese Yen, for whatever reason, weakens sharply to the 130 barrier level, then the knock-in (or the reverse knock-in) JPY puts will come alive at a huge intrinsic value for the bank (buyer of the reverse knock-ins). Then all the bank's remaining USD calls/JPY puts would become viable and the company would be required to sell US dollars at 105 at a great intrinsic value (huge loss for the company).
However, given the fact that the transaction was executed in the first half of 2004 and it was of one year maturity, it seems that the Treasurer of the company made a good judgment call.
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