The Risk Reversal

For Importers

The risk reversal closely resembles a protection option but has capped upside potential to make the overall structure cheaper for the client. Clients have the flexibility to buy at the spot rate on maturity if it falls between the worst case and best case strike rates. If the spot rate on maturity is either superior to the best case strike rate or inferior to the worst case strike rate the client is obliged to buy at the respective best or worst case strike rates.

How does a risk reversal work?

For example, let's assume a client imports furniture from the US, and needs to buy US$1 million in six months' time to pay a supplier.

The forward rate for six months is 0.6800 and the client doesn't want to get a worse rate than 0.6800. However, the client thinks that the Australian dollar is going to strengthen further against the US dollar. The client does want an option that offers some upside potential but felt that 3% premium for a protection option at 0.6800 was more than the company wanted to pay.

To reduce the premium, the client was happy to cap their upside potential and set a best case strike rate of 0.7400 and keep their worst case strike rate of 0.6800. This reduced the premium paid to 1%.

This meant that regardless of what happened to the exchange rate over the next six months, if the rate was lower than 0.6800 on the pre-agreed date in six months' time, he could convert his Australian dollars into US dollars at 0.6800.

Possible scenarios:

Scenario 1: AUD/USD weakens and at maturity the exchange rate is 0.6200.

The client is obliged to buy US dollars at the worst case strike rate of 0.6800

Scenario 2: AUD/USD strengthens and at maturity the exchange rate is 0.7800.

The client is obliged to buy US dollars at the best case strike rate of 0.7400

Scenario 3: AUD/USD is 0.7200 at maturity (the exchange rate is between the worst case and best case strike rates).

The client has the right to buy US dollars at 0.7200

Advantages

Certainty of a worst case rate

The client has 100% protection if the rate moves against him

Allows you to benefit from favourable currency moves up to the best case strike rate (0.7400 in the above example)

Disadvantages

An upfront premium is payable in this case (1% of the notional = $10,000) although Risk Reversals can be structures so that there is zero premium to pay.

For Exporters

The risk reversal closely resembles a protection option but has capped upside potential to make the overall structure cheaper for the client. Clients have the flexibility to buy at the spot rate on maturity if it falls between the worst case and best case strike rates. If the spot rate on maturity is either superior to the best case strike rate or inferior to the worst case strike rate the client is obliged to buy at the respective best or worst case strike rates.

How does a risk reversal work?

For example, let's assume a client exports widgets to the US, and she forecasts that she will need to repatriate US dollar proceeds of US$1 million in six months' time.

The forward rate for six months is 0.6800 and the client doesn't want to get a worse rate than 0.6800. However, the client thinks that the Australian dollar is going to weaken further against the US dollar. The client does want an option that offers some upside potential but felt that 3% premium for a protection option at 0.6800 was more than the company wanted to pay.

To reduce the premium, the client was happy to cap their upside potential and set a best case strike rate of 0.6200 and keep their worst case strike rate of 0.6800. This reduced the premium paid to 1%.

This meant that regardless of what happened to the exchange rate over the next six months, if the rate was higher than 0.6800 on the pre-agreed date in six months' time, she could convert her US dollars into Australian dollars at 0.6800.

Possible scenarios:

Scenario 1: AUD/USD strengthens and at maturity the exchange rate is 0.7200.

The client is obliged to sell US dollars at the worst case strike rate of 0.6800

Scenario 2: AUD/USD weakens and at maturity the exchange rate is 0.6000.

The client is obliged to sell US dollars at the best case strike rate of 0.6200

Scenario 3: AUD/USD is 0.6400 at maturity (the exchange rate is between the worst case and best case strike rates).

The client has the right to sell US dollars at 0.6400

Advantages

Certainty of a worst case rate

The client has 100% protection if the rate moves against her

Allows the client to benefit from favourable currency moves up to the best case strike rate (0.6200 in the above example)

Disadvantages

An upfront premium is payable in this case (1% of the notional = $10,000) although Risk Reversals can be structures so that there is zero premium to pay

World First Pty Ltd holds an Australian Financial Services Licence - Licence No: 331945 -under the Corporations Act 2001 which authorises it to provide financial services in relation to foreign exchange contracts, derivatives and non cash payments facilities to persons within Australia.

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