Asymmetric Forward Knock Out is a product which is structured in order to hedge the foreign currency (FX) risk. Asymmetric Forward
Knock Out structure allows the hedger
to make the FX transaction with a better rate than the forward rate. The notional amount of the transaction depends on the value of the spot rate at the expiry date. If the spot at the expiry date is at a disadvantageous level according to forward level, hedger must do the transaction with a leveraged amount. For example if the leverage ratio is 2 and the notional amount is 1,000,000 then hedger will make the FX transaction with an amount of 1,000,000 when spot rate at maturity is at an advantageous level according to forward rate. On the other hand the hedger must buy/sell 2,000,000 when the spot rate at expiry is at a disadvantageous level. Thus hedger increases the probability of the hedge to be in the money at the expiry date. On the other hand this transaction also increases the potential loss amount of the hedge because of the leverage ratio.
Asymmetric Forward Knock Out structure has a Knock Out level different than the
standart Asymetric Forward structure. If spot price touches to Knock Out level
through the life of the product, structure cancels and no FX trasaction is
realized at the maturity of the product.
Knock Out level can be in two different ways. Structure can be canceled if the
market moves in favor of the hedger or structure can be canceled if the market
moves to a disadvantages level for the hedger. While first option leads the
structure to have better rate according to standart asymetric forward product,
second option leads the structure to have worse rate according to standart
asymetric forward product.
There are three parameters in order to price the Asymmetric Forward Knock Out
structure. One is leverage ratio, the other is the asymmetric forward level
and the last one is the Knock Out level. Hedger gives the desired value of two of these parameters to the market maker and market maker quotes the other parameter by making the structure zero cost for the hedger.
On the pricing screen user enters both of these parameters to Derivative Engines pricing tool and value of the structure is displayed as the result. A Hedger can price Asymmetric Forward structure easily with Derivative Engines seeking for the zero cost by changing the value of the parameters.
Leverage Ratio: Hedger buys an in the money option and sells an out of the money option. Hedger does not pay any premium for the structure. The leverage ratio is the ratio of the notional amount of the option that customer sells to the notional amount of the option that customer buys.
Applications:
When Asymmetric Forward Knock Out is done for Hedging purposes the leverage amount should be equal to the foreign currency risk of the hedger. For example; when a hedger who has a short position at EUR/USD parity, makes the Asymmetric forward
Knock Out product with a leverage ratio of two, the maximum amount that will be bought should be EUR 1,000,000. This means that when spot rate at maturity is in favor of hedger, the FX transaction amount will be EUR 500,000 otherwise it will be EUR 1,000,000. If hedger makes the transaction as EUR 1,000,000 to EUR 2,000,000 then this will cause a speculative position for the hedger. Since the risk amount to be hedged is EUR 1,000,000 the hedger has the risk to make a EUR 2,000,000 transaction.
If the structure is designed that will be Knocked Out when the market moves in
favor of the hedger then the hedger does not protected from the large market
moves. A hedger should be very careful when using the Knock Out property in such
a way.
Advantages:
-
Hedger makes the transaction from a better rate than
the forward price.
-
Product is formed costless
-
If Knock Out is used to limit the potential loss of the structure, when market
moves to a disadvantage level product can be canceled.
Disadvantages:
-
If at maturity spot rate is not in
favor of hedger the loss coming from the transaction is leveraged with the
leverage ratio.
-
If Knock Out level is used in order to make improve the standart Asymetric
Forward rate, when market moves in favor of hedger structure can be canceled.
