Geistesblitz 20/03

Geistesblitz 20/03

Step-Up Forward


Initial Situation


After a short, strong rally around the turn of the month, the EUR-USD exchange rate has recently fallen sharply again. As predominantly in the last two years, the USD is showing strength. The EUR was even within striking distance of its 3-year low for a short time. In view of the possible consequences of the shutdown in the context of the Corona crisis, however, doubts are being raised about the sustainability of this trend. The last few days have already shown a strong recovery. The galloping US national debt and a narrowing interest rate differential with the EUR zone may help further rebound the EUR. In the current situation, importers with USD payables are affected multiple times. Primarily from the lower exchange rates and additionally from the shrunken forward premiums. If they would like to be prepared for an even weaker EUR and at the same time participate in a possibly stronger one, an optional hedge would be appropriate. However, these have recently become dramatically more expensive. The EUR-USD volatilities, which have been declining for a long time, have more than doubled recently due to tension in the financial markets. For example, the 6-month ATM volatility has risen from approx. 4.4% to approx. 12.5% and currently stands at approx. 8.8%.


Figure 1: EUR-USD 6-month ATM volatility over the last five years 


With the current Geistesblitz we would like to point out a possible solution to this dilemma for USD importers. We present a strategy that allows your customers to fully hedge against a falling EUR-USD exchange rate without having to forego an exchange rate improvement in case of a EUR-USD countermove.

Market overview (March 27th
2020)
 

  • EUR-USD spot rate: 1.1045 USD/EUR
  • 6-month EUR-USD forward rate (incl. margin): 1.1140 USD/EUR

Figure 2: EUR-USD spot rate over the last five years

Step-Up Forward 


Product description:

The importer concludes a "Step-Up Forward" from which he acquires 2,000,000 USD in 6 months at an exchange rate of 1.0800 USD/EUR against EUR. This corresponds to a reduction compared to the spot rate as well as the forward rate in the amount of 0.0245 USD/EUR and 0.0340 USD/EUR respectively. In turn, the customer has the chance of an exchange rate improvement in case of a further rise in EUR-USD. The exchange rate improvement is stepwise and depends on the exchange rate at maturity. In the best case, the highest bonus rate of 1.1800 USD/EUR can be achieved, an exchange rate level last reached in September 2018. However, if the exchange rate barrier of 1.2300 USD/EUR is reached or exceeded during the next 6 months, the exchange rate improvements will not apply. Your customer will be settled at the guaranteed rate 1.0800 USD/EUR. The exchange rate barrier helps to mitigate the significantly higher costs of participating in rising rates. Despite rapidly increasing exchange rate volatility, this offers a chance of very attractive hedging rates as long as 1.2300 USD/EUR is not reached.


Indicative terms and conditions:

  • Notional: 2,000,000 USD
  • Maturity: 6 months
  • Guaranteed rate: 1.0800 USD/EUR
  • Bonus rate 1: 1.1140 USD/EUR if the spot rate at maturity is at least 1.1140 USD/EUR (but below 1.1470 USD/EUR)
  • Bonus rate 2: 1.1470 USD/EUR if the spot rate at maturity is at least 1.1470 USD/EUR (but below 1.1800 USD/EUR)    
  • Bonus rate 3: 1.1800 USD/EUR if the spot rate at maturity is at least 1.1800 USD/EUR 
  • Exchange rate barrier: 1.2300 USD/EUR, if reached or exceeded during the lifetime of the strategy (continuous fixing), the bonus rates do not apply.

Figure 3: Graphical representation of the hedged rate

Benefits and Risks from a client perspective:

Benefits:
  • Hedging USD payables at a minimum EUR-USD rate, guaranteed rate 1.0800 USD/EUR.
  • Purchase of the USD at one of the three bonus rates with price improvement of up to 0.1000 USD/EUR (to 1.1800 USD/EUR) in the event of a rising EUR-USD exchange rate at maturity.
Risks:
  • Hedged rate is 0.0245 USD/EUR below the current spot rate (1.1045 USD/EUR) and 0.0340 USD/EUR below the alternative forward rate (1.1140 USD/EUR).
  • The possibility to improve on one of the three bonus rates does not apply, if the EUR-USD exchange rate trades at or above the exchange rate barrier (1.2300 USD/EUR) at least once until maturity. 


In a nutshell


In the current Geistesblitz "Step-Up Forward" customers with USD payables agree to a EUR-USD minimum rate below the current spot rate of 1.1045 USD/EUR. In turn, they have the opportunity to participate in case of a further rising EUR-USD exchange rate by stepwise improving their exchange rate. In the best case, the bonus rate of 1.1800 USD/EUR can be achieved. By using an exchange rate barrier, the strategy takes advantage of the increased exchange rate volatility. It offers the opportunity to reach hedging levels that would otherwise be difficult to achieve with standard solutions in an environment with lower exchange rates and increased volatility.

LPA

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