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Can investee companies with foreign currency receivables simultaneously benefit from a weaker pound and rising volatility?
Many veteran traders opine that when volatility is cheap, it is often not cheap enough and when expensive, it is not expensive enough. The implication is that the market is too slow to adjust to implied volatility – and hence option prices – when conditions change rapidly.
Whether sufficiently quickly or not, the market has certainly moved its pricing for GBP implied volatility sharply higher so far this year. Since year end, GBP/USD three month implied volatility has moved up from under 9% to almost 16%. This means that the cost of a three month at the money put option to protect against GBP depreciation against the USD has increased by over 80%. This has much to do with concern over Brexit.
Whether such option pricing will be justified by the actual volatility experienced when we look back in six months’ time is parked squarely in the ‘we shall have to wait and see’ space.
Many GPs and their investee companies usually view option premiums as too expensive and prefer to use premium free, fixed protection, such as forwards to hedge FX exposures. However, if one always views options as too expensive, logic dictates that one should consider selling them.
A EUR-denominated fund, with a USD investment for example, might consider selling USD call options against the EUR. This would mean that the fund would not benefit from any USD appreciation beyond the strike price of the option. However, it would collect the option premium. This technique of selling ‘covered calls’ (covered, since the fund has underlying long USD exposure) is a commonly-used strategy amongst equity fund managers but is rarely used by GPs in private equity.
The reason for this is liquidity. A fund manager who sells a covered call can physically deliver underlying shares if the sold option expires in the money. A private equity fund’s assets, on the other hand, are illiquid. In the absence of USD to deliver, a PE fund pursuing this strategy could end up buying USD in the market to physically deliver at a loss in ordered to fulfil the expiring options contract.
However, an investee company with USD receivables is in a better position to take advantage of this strategy. USD calls could be sold, raising premium that could be used to buy USD put options to protect against a weaker USD. This works particularly well after a large advantageous FX movement, where the current exchange rate is better than budget. In this scenario, the sold USD call can be struck very close to, or at, the money, while the bought USD put can be struck somewhat out of the money – but still well within budget – meaning that the company will receive net premium.
Ahead of the forthcoming UK referendum on Brexit, sterling is quite likely to exhibit further weakness, providing investee companies with foreign currency receivables the opportunity to benefit from this strategy.
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