Zero Cost Collar Knock Out



Collar Knock Out product is a structured product which is done generaly for hedging purposes. Instead of doing a simple forward contract hedger has a flexibility to buy/sell a foreign currency from a price range. The price range allows the hedger to speculate the market according to his market view rather than fixing the price in forward. Two price level forms the range and hedger knows that at the expiry date if the spot price is above the upper band level then the foreign currency transaction will be from the upper band level and if the spot price is below the lower band level then the foreign currency transaction will be from the lower band level. The Collar Knock Out products has a Knock Out level different than the classic Collar product. The Knock Out level leads the product to have better band level than the classic collar. On the other hand the Knock Out level caps the profit potential of the hedger. When the market moves to Knock Out level the product will be in the money but when market touches to Knock Out level structure is canceled and hedger losses his protection.

For example a hedger who has a short position at USD/TRY parity in a two month period makes the Collar product to hedge his fx exposure. The hedger must buy USD and sell TRY at the expiry date in order to hedge the short position on USD/TRY. When Collar Knock Out product is used for such a hedging need, the upper band level will be at a higher level than the forward price and the lower band level will be at a lower level than the forward price. When spot price is greater than the upper band level at the expiry date hedger will buy USD/TRY from the upper band level which is at a advantageous level according to spot price (If market does not touch to Knock Out level). When spot price is lower than the upper band level at the expiry date hedger will buy USD/TRY from the lower band level which is at a disadvantageous level according to spot price. 

In fact hedger buys a Call option with the strike price of upper band level and sells a put option with the strike price of lower band level. Both options have  Knock Out at the same level. The premiums of the both options will be equal to each other and hedger does not receive or pay any premium for the structure.

Applications:

Collar Knock Out product can be suitable for the hedgers who want to hedge their foreign currency exposure but also want to apply their view about future price of the underlying currency. Some of the institutions use the worst case level in their budgets. If the market moves to up for a buyer than the upper band at collar will be their worst case level for hedging. In fact the hedger does not protected from the large market moves. A hedger should be very careful when using Collar Knock Out structure for hedging purposes.



Advantages


-          If price of the underlying currency pair moves inline with the side of the product (If collar knock out is used to buy, a move to the upside in the market is an example of such a move) then hedger makes the foreign currency transaction with a better rate than the spot rate at the expiry date.

-         
Hedger has the flexiblity to speculate the market in a price range according to his views.


Disadvantages


-          If the price of the underlying asset moves against the side of the product hedger may do the foreign currency transaction at a worse rate than the spot price.

-          If market makes a large move in favor of the hedger then the structure can be canceled.



  • Financial Asset                                       : USD/TRY
  • Position at maturity                               : USD Long
  • AMount                                                      : USD 1,000,000
  • Spot Rate                                                  : 1.5500
  • Forward Rate                                           : 1.5580
  • Knock Out Level                                     : 1.6500
  • Collar Upper Band Level                       : 1.6100
  • Collar Lower Band Level                      : 1.5300
  • Tenor                                                         : 30 days

    When the above informations are input to pricing screen of Derivative Engines the real time market price of the Collar Knock Out will be quoted. Price of the structure are quoted by considering the real time market bid / ask spreads. Below the payoff chart of the above example can be seen.
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    Below you can find the payoff graphs of the option buyer and the option seller.





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