Zero cost hedging structures have soared in popularity in recent years. Once reserved for the big end of town, they’re now being marketed to a broader audience.
The RBA’s Foreign Exchange Turnover report shows that around $1.5 billion in Over the Counter (OTC) FX Options are being traded daily.
Zero Cost hedging structures typically include one or more options. Marketers often disguise this with clever names, as options have a reputation for appearing overly complex and risky. Despite this, they can still be suitable for SMEs.
How zero cost hedges work
To understand how a zero cost hedge can be structured, consider the cashflow implications of buying and selling (aka writing) an option. Buying an option usually means paying a premium (negative cashflow) while selling an option sees a premium received (positive cashflow).
By netting these two cashflows, the two-legged option structure (simultaneous buy and sell) can become cashflow neutral, if premium paid = premium received.
For example, an Australian importer has a US dollar payment to make in three months’ time. If the current AUD/USD spot rate is trading at around 1.0250 then a zero cost hedge can be structured as follows:
Leg 1 – buy an AUD Put/USD Call with strike price at 1.0100 AND
Leg 2 – sell an AUD Call/USD Put with strike price at 1.0400
Now if both of these options are due to expire in three months’ time then it may be possible that the premium paid (Leg 1) and the premium received (Leg 2) are the same, i.e. cashflow neutral
So how do FX providers make money?
If the structure is cashflow neutral and doesn’t cost the customer anything, how does the FX provider make their money?
In reality, the provider of the zero cost hedge will structure the two legs so as the cashflows are actually positive for them, without passing on the benefit to the customer. So if the premium received is more than the premium paid (or vice versa) then the FX provider may receive positive cashflow which in essence, is revenue for them.
So it is possible for a business to turn what is pitched to them as a zero cost hedge into a cashflow positive position, generating a revenue stream for the business not the FX provider.
Zero cost does NOT mean zero risk
Call it human nature, but people seem to assume that something free (zero cost) carries no risk. In this case it is not true.
There are a few things to look out for so it’s vital, no matter how painful it may seem, to ensure you read the accompanying Product Disclosure Statement (PDS). In particular, look out for potential margin calls or any “layers” most commonly referred to as “Knock In” or “Knock Out” exchange rate levels.
These let the option writer avoid exposure to large losses, but they may also be obliged to trade at a worse than market rate if the Knock In rate is reached any time prior to expiry.
Options can be simple
An option can be a very simple yet effective hedging tool for businesses. It is when they are combined through multiple legs and include knock in/knock out rate layers that they become overly complex. It may also be more beneficial (although not so popular) to pay an upfront option premium rather than seek a zero cost version that can add complexity and risk.
No matter what you choose to do, be sure to demand transparency from your FX provider. Ask what the premium would be for each leg and consider alternatives to what is being proposed. In some instances a simple Forward Exchange Contract (FEC) may satisfy your business objective to mitigate risk, as would a straight up option or a combination of an FEC and option, most commonly referred to as a Participating Forward.
Zero cost hedging can be a complex topic to get your head around, so if you would like to know more then OzForex gave a recent free educational Webinar on the subject.
Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.