FX Options and Structured Products

UWE WYSTUP is the founder and managing director of Math-Finance AG, a consulting and software company specializing in quantitative finance, implementation of derivatives models, valuation and validation services. During his career, he worked as a financial engineer, structurer and consultant in FX options trading teams for such banks as Commerzbank, Deutsche Bank, Citibank, UBS and Sal. Oppenheim jr. & Cie. An internationally known FX options expert in academia and practice, he lectures on financial engineering as an honorary professor at Frankfurt School of Finance & Management and a professor of financial option price modeling and foreign exchange derivatives at Antwerp University, in addition to giving seminars all over the world. He coedited (with Jürgen Hakala) the industry standard, Foreign Exchange Risk.

• List of Tables xiiiList of Figures xviiPreface xxiAbout the Author xxiiiAcknowledgments xxvChapter 1 Foreign Exchange Derivatives 11.1 Literature Review 11.2 A Journey through the History of Options 11.3 Currency Options 31.4 Technical Issues for Vanilla Options 41.4.1 Valuation in the Black-Scholes Model 61.4.2 A Note on the Forward 81.4.3 Vanilla Greeks in the Black-Scholes Model 81.4.4 Reoccurring Identities 111.4.5 Homogeneity based Relationships 131.4.6 Quotation Conventions 141.4.7 Strike in Terms of Delta 201.4.8 Volatility in Terms of Delta 211.4.9 Volatility and Delta for a Given Strike 211.4.10 Greeks in Terms of Deltas 221.4.11 Settlement 261.4.12 Exercises 301.5 Volatility 331.5.1 Historic Volatility 331.5.2 Historic Correlation 361.5.3 Volatility Smile 371.5.4 At-The-Money Volatility Interpolation 441.5.5 Volatility Smile Conventions 451.5.6 At-The-Money Definition 451.5.7 Interpolation of the Volatility on Fixed Maturity Pillars 451.5.8 Interpolation of the Volatility Spread between Maturity Pillars 481.5.9 Volatility Sources 491.5.10 Volatility Cones 521.5.11 Stochastic Volatility 521.5.12 Exercises 541.6 Basic Strategies Containing Vanilla Options 551.6.1 Call and Put Spread 561.6.2 Risk Reversal 611.6.3 Straddle 641.6.4 Strangle 651.6.5 Butterfly 671.6.6 Condor 701.6.7 Seagull 721.6.8 Calendar Spread 751.6.9 Exercises 751.7 First Generation Exotics 761.7.1 Classification 761.7.2 European Digitals and the Windmill Effect 771.7.3 Barrier Options 811.7.4 Touch Contracts 931.7.5 Compound and Installment 1051.7.6 Asian Options 1171.7.7 Lookback Options 1261.7.8 Forward Start, Ratchet, and Cliquet Options 1361.7.9 Power Options 1381.7.10 Quanto Options 1471.7.11 Exercises 1521.8 Second Generation Exotics (Single Currency Pair) 1561.8.1 Multiplicity Power Options 1561.8.2 Corridors/Range Accruals 1571.8.3 Faders 1601.8.4 Exotic Barrier Options 1621.8.5 Pay-Later Options 1661.8.6 Step Up and Step Down Options 1691.8.7 Options and Forwards on the Harmonic Average 1691.8.8 Variance and Volatility Swaps 1701.8.9 Forward Volatility Agreements (FVAs) 1741.8.10 Exercises 1761.9 Second Generation Exotics (Multiple Currency Pairs) 1771.9.1 Spread and Exchange Options 1771.9.2 Baskets 1791.9.3 Outside Barrier Options 1851.9.4 Best-of and Worst-of Options 1881.9.5 Other Multi-Currency Options 1911.9.6 Correlation Swap 1921.9.7 Exercises 192Chapter 2 Structured Products 1972.1 Forward Transactions 1972.1.1 Outright Forward 1982.1.2 Participating Forward 2002.1.3 Participating Collar 2022.1.4 Fade-In Forward 2032.1.5 Knock-Out Forward 2052.1.6 Shark Forward 2062.1.7 Fader Shark Forward 2102.1.8 Butterfly Forward 2122.1.9 Range Forward 2142.1.10 Range Accrual Forward 2152.1.11 Accumulative Forward 2182.1.12 Boomerang Forward 2242.1.13 Amortizing Forward 2252.1.14 Auto-Renewal Forward 2272.1.15 Double Shark Forward 2282.1.16 Forward Start Chooser Forward 2292.1.17 Free Style Forward 2292.1.18 Boosted Spot/Forward 2292.1.19 Flexi Forward/Time Option 2312.1.20 Strike Leverage Forward 2322.1.21 Escalator Ratio Forward 2322.1.22 Intrinsic Value Ratio Knock-Out Forward 2342.1.23 Tender Linked Forward 2362.1.24 Exercises 2372.2 Target Forwards 2412.2.1 Plain Target Forward 2412.2.2 Leveraged Target Forward 2442.2.3 Target Profit Forward 2462.2.4 Pivot Target Forward (PTF) 2522.2.5 KIKO Tarn 2552.2.6 Target Forwards in the Media 2592.2.7 Valuation and Hedging of Target Forwards 2602.2.8 Exercises 2652.3 Series of Strategies 2662.3.1 Shark Forward Series 2672.3.2 Collar Extra Series 2692.3.3 Exercises 2702.4 Deposits, Loans, Bonds, and Certificates 2702.4.1 Dual Currency Deposit/Loan 2702.4.2 Performance-Linked Deposits 2732.4.3 Tunnel Deposit/Loan 2752.4.4 Corridor Deposit/Loan 2772.4.5 Turbo Deposit/Loan 2792.4.6 Tower Deposit/Loan 2812.4.7 FX-linked Bonds 2832.4.8 FX-Express Certificate 2842.4.9 Exercises 2852.5 Interest Rate and Cross Currency Swaps 2862.5.1 Cross Currency Swap 2862.5.2 Hanseatic Swap 2932.5.3 Turbo Cross Currency Swap 2962.5.4 Buffered Cross Currency Swap 2982.5.5 Flip Swap 2992.5.6 Corridor Swap 3012.5.7 Currency Related Swap (CRS) 3032.5.8 Double-No-Touch Linked Swap 3072.5.9 Range Reset Swap 3092.5.10 Exercises 3092.6 Participation Notes 3102.6.1 Gold Participation Note 3102.6.2 Basket-Linked Note 3122.6.3 Issuer Swap 3132.6.4 Moving Strike Turbo Spot Unlimited 3132.7 Hybrid FX Products 3142.7.1 Long-Term FX Options 3152.7.2 Power Reverse Dual Currency Bonds 3152.7.3 Hybrid Forward Contracts 3202.7.4 Dual Asset Range Accrual Note 3212.8 Treasury Case Studies 3222.8.1 FX Protection for EM Currencies with High Swap Points 3222.8.2 Exit Strategies for a Sick Floan 3232.8.3 Trade Ideas for FX Risk Management in View of Brexit 3282.8.4 Inverse DCD 3302.8.5 Exercises 331Chapter 3 Hedge Accounting 3353.1 Hedge Accounting under IAS 39 3353.1.1 Introduction 3353.1.2 Financial Instruments 3363.1.3 Evaluation of Financial Instruments 3493.1.4 Hedge Accounting 3563.1.5 Methods for Testing Hedge Effectiveness 3643.1.6 Testing for Effectiveness – A Case Study of the Forward Plus 3723.1.7 Conclusion 3903.1.8 Relevant Original Sources for Accounting Standards 3923.2 Hedge Accounting under IFRS 9 3923.2.1 Hedge Effectiveness 3923.2.2 Documentation and Qualifying Criteria 3933.2.3 Case Study: Shark Forward 3933.2.4 Conclusion and Outlook 397Chapter 4 Foreign Exchange Markets 3994.1 Vanna-Volga Pricing 3994.1.1 Cost of Vanna and Volga 3994.1.2 Observations 4024.1.3 Consistency Check 4034.1.4 Adjustment Factor 4054.1.5 Volatility for Risk Reversals, Butterflies, and Theoretical Value 4054.1.6 Pricing Barrier Options 4054.1.7 Pricing Double Barrier Options 4064.1.8 Pricing Double-No-Touch Contracts 4064.1.9 Pricing Path-Independent Contracts 4074.1.10 No-Touch Probability 4074.1.11 The Cost of Trading and its Implication on the One-Touch MTM 4074.1.12 Example 4094.1.13 Further Applications 4104.1.14 Critical Assessment 4104.2 Bid-Ask Spreads 4104.2.1 Vanilla Spreads 4114.2.2 Spreading Vanilla Structures 4124.2.3 One-Touch Spreads 4124.2.4 Spreads for First Generation Exotics 4124.2.5 Minimal Bid-Ask Spread 4134.2.6 Bid-Ask Prices 4134.3 Systems and Software 4134.3.1 Position Keeping 4144.3.2 Reference Prices and Volatilities 4144.3.3 Straight Through Processing 4144.3.4 Disclaimers 4154.4 Trading and Sales 4154.4.1 Proprietary Trading 4164.4.2 Sales-Driven Trading 4164.4.3 Inter Bank Sales 4164.4.4 Branch Sales 4164.4.5 Institutional Sales 4164.4.6 Corporate Sales 4174.4.7 Private Banking 4174.4.8 Retail FX Derivatives 4174.4.9 Exchange Traded FX Derivatives 4174.4.10 Casino FX Products 4174.4.11 Treasury 4184.4.12 Fixings and Cutoffs 4184.4.13 Trading Floor Joke 4214.5 Currency Pairs 4214.5.1 ISO 4217 Currency Code List 4214.6 Things to Remember 4244.7 Glossary 424Bibliography 427Index 433