Option Types – Knock-Out Options

Purpose

Knock-out options have been designed to provide a high level of foreign exchange protection or leverage at a lower cost than vanilla currency options, but without imposing upon a hedger’s ability to profit from favourable currency movements. Often a hedger will purchase a knock-out option for protection and then place an order to execute a spot contract if the more favourable option trigger price is hit, and then roll it forward to the needed delivery date.

From a trader’s perspective, a long knock-out option position can be entered into at lower premium cost than a vanilla option and structured with an automatic stop-loss equal to the trigger price. Traders can also sell knock-out options with triggers that they believe are likely to be hit to capture the premium when the options are cancelled.

Description

A purchased knock-out option provides a hedger with protection against adverse currency movements in a similar way to a vanilla currency option. In addition to the normal currency option variables, the buyer also selects a knock-out price which is the level of the underlying exchange rate that, when hit, will cancel the option and leave the hedger’s exposure uncovered. If the knock-out price is reached before the option matures, the buyer must then choose between remaining uncovered, dealing in the spot or forward markets or selecting new option protection. If the knock-out price is not reached, the option is settled at expiry like the equivalent vanilla options.

Knock-out levels are usually set such that the option lapses when it is out of-the-money, i.e. when the spot price has moved in a direction unfavourable for the option, but favourable for the underlying exposure. The exact rate chosen may depend upon the customer's currency forecasts or may be related to the relative premium cost of the option. The closer the knock-out level is to the current spot rate, the cheaper the option.

Generally, knock-out levels are set strategically at a point where the hedger will be happy to initiate spot/forward cover, or perhaps at a level just above/below important technical resistance/support levels to reduce the risk of the option’s knock-out level being triggered.

Typical Use in Hedging

  • A company wishing to gain cost-effective protection against unfavourable currency movements when they expect the spot rate will trend in the favour of their underlying exposure without significant corrections.

Exporter Example

Exposure

Consider the case of an Australia-based exporter with USD 10,000,000 in receipts due in three months. At that time, the exporter needs to buy AUD and sell USD in that amount. The current AUD/USD spot price is 0.5700 while the three month forward rate is 0.5710.

Market View

The exporter is unsure of the future direction of the AUD against the USD. They wish to protect against an adverse currency movement, but they would like to gain from any favourable depreciation in the AUD versus the USD. They would be happy to hedge in the spot market if the rate reaches 0.5400.

Possible Solution

The hedger could purchase a three-month AUD Call/USD Put knock-out option with a 0.5700 strike price and a 0.5400 knock-out trigger for a premium of USD 150,000 or 1.50% of the USD 10,000,000 face value of the contract. (In comparison, a vanilla European-style three-month AUD Call/USD Put with a 0.6500 strike price would cost significantly more at 1.80% or USD 180,000.) They would also simultaneously place an order in the spot market to sell USD 10,000,000 and buy AUD at the option’s trigger price of 0.5400.

Possible Outcomes

  1. If the AUD/USD spot rate trades at USD 0.5400 (the knock-out rate) before the option matures, the option automatically lapses leaving the hedger without cover. At this point, their order to deal in the spot market will also be executed and their effective exchange rate will be 0.5400 plus the option’s premium expressed in pips. If they did not want to sell their USD 10,000,000 for value spot, they could also roll forward to cover in the forward market or select to protect their exposure with a new option hedge strategy.
  2. If the AUD/USD exchange rate is above 0.5700 at expiration and the option has not been knocked-out, the hedger will exercise the AUD call/USD put option to sell USD 10,000,000. In this case, their effective exchange rate will be equal to the strike price plus the option’s premium expressed in pips.
  3. If the AUD is between 0.5700 and 0.5400, the hedger will simply allow their option to lapse and will buy AUD and sell USD 10,000,000 in the spot market.  Their effective exchange rate will be the spot rate plus the option’s premium expressed in pips.

 

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