Both puts and calls start off, in the 1 week tenor, as might be anticipated.  The payout for both is on average slightly above 80% of the premium.  Thus they are both slightly ‘expensive’; in theory one could generate returns by selling these short dated options.

This seems reasonable; we know that some hedge funds use short dated option selling strategies (though it’s a high risk trade).  But as we look at longer tenors, the story gets very strange.  Calls, which pay out for appreciation of the base currency, become very poor value, returning on average only about 50% to their owners in the 3 year tenor.  Puts by contrast return 130% for the same tenor!  This is not a small effect; it is an enormous anomaly which has gone completely unnoticed up until now.  This really is the elephant in the room.

Historical data analysis

How has it not previously been realised that there is this significant effect?  Very simply, because nobody has made the very considerable effort that it took to collect and clean the data, and perform the historical back tests2.  There are two main types of FX option user, which we can refer to as static traders (hedgers) and dynamic traders (investors).  A static trader or hedger, such as a corporate treasurer, would be interested in the ratio of premium to payout, to judge whether option protection was a good idea.  But only in the very largest global companies will there be the expertise to perform the historical analysis; while the results would be of interest, it’s unlikely that they would be known or discovered.  In contrast, a dynamic trader (for example on an option trading desk) will typically have many option positions and may trade day-to-day if not intraday in order to maximise the returns on a portfolio. They tend to think in terms of how much can be made from the risk management of an option. The resulting payoff-to-premium ratio for a contract is not of interest.  Thus while an option desk would have the expertise to decide whether there is a systematic difference between premium and payoff, they would not have any interest in doing so.

It is, to put it mildly, odd that there is so little effort made to analyse historical data, particularly when there is huge and careful effort put into the initial valuation of derivative contracts.  If the post-trade performance of different contract types had been considered to be important from the start, then there would have been regular evaluation of the situation and it would have been understood a long time ago.  As it is, popular products, with billions of flow dollars spent on them each day, have been unknown entities when it comes to calculating their average payback.  This is not clever.  Financial institutions are not the only culprits.  Academia, usually so focussed on data, has neglected the fact that historical data are of poor quality and patchy.  Study after study on financial markets is done on tiny datasets with poor quality control, and nobody appears to complain. 

Now is the perfect time for the financial world to review this situation.  Increased scrutiny and regulation mean that global markets have an urgent need to increase fairness and transparency, and to be seen to be doing so. We are overdue a change of attitude.

Hedging with options

Some of this historical data analysis has yielded fascinating results with important implication for hedgers.  In figure 3, we show the average results of hedging various Emerging Markets FX exposures.  In this case the exposure to the EM currency is positive, ie, the risk is from depreciation of the EM currency.  Because the forward rate always locks in a degree of depreciation which rarely actually occurs, these hedges are costly.

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Figure 3: Average cash flow for 3 month hedges of positive EM FX exposure          Source: Bloomberg and Commerzbank

On average, the quarterly forward hedges cost 6% of the notional amount per year; a very large expense.  But, the difference between forward and option hedges is unambiguous – even including the full premium and bid-offer costs, the options cost on average is just over half of the forward cost.  Twenty out of the twenty-five currency pairs tested have the option cost as less than the forward cost, and the five exceptions have smaller data sets.  In the past at least, options have delivered far cheaper hedges.  We repeated the backtest using 25-delta out-of-the money long call option positions.  We found that the supposedly more exotic OTM options are actually cheaper hedges again than both the ATMF options and the long forward contracts.  In this case they are on average about one third of the cost of the forwards, once more including premium and bid-offer costs.  Additionally, in case the cheaper option hedges provided poor protective qualities, we examined the hedge cash flows in the worst ever depreciation periods for the EM currencies.  In the vast majority of cases, the option hedges provided similar protection, to about 90% of the level provided by the forward contracts.  While remaining vastly cheaper, they still deliver value during high risk times.

2 This is the research which underlies the book we have recently completed, published by Wiley, called FX Option Performance.

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