To channel former US secretary of defence Donald Rumsfeld, if 2015 was characterised by "unknown unknowns" – the startling 18% appreciation in the Swiss franc against the euro and the surprise 3% devaluation of the strictly controlled Chinese renminbi – then the 2016 foreign exchange market was marked by known unknowns.
The UK's referendum on whether to remain in the European Union was scheduled for June 23, 2016, and marked firmly on every bank's calendar, as was the US presidential election on November 8. Shutting up shop was not an option, so banks sought to approach each event with a reasonably flat book and tackle potential problems well in advance.
HSBC, this year's winner, did exactly that. To take one example, in the weeks leading up to the UK's decision to leave the EU, its forex options team realised its usual method of pricing options could prove misleading.
"If we had not adjusted the pricing methodology in the build-up to the vote, then it would have meant on every ticket we would have been making or losing money for the wrong reason," says Pascal Passeron, forex and precious metals options trader at HSBC.
Typically, a forex options desk will price the most heavily traded dates for a given product – such as one-month, three-month and one-year – and then draw a line, or ‘interpolate', between those points to create a full curve. However, if a big event sits between two of these points, traditional interpolation could result in mispricing.
For Brexit we created an additional way to put further dates into the system, where you could bend the interpolation around those dates for the volatility smile on top of doing it for ATM options
Charlie Chamberlain, HSBC
HSBC spotted this risk as the event approached and it became clear there was the potential for a cliff-like move following the vote. The expected rally in GBP/USD on a Remain win was only forecast at 3%, whereas the expected collapse in the currency pair if Leave won could be as much as 15%, the bank predicted.
"There was a massive asymmetry in the potential outcome," says Passeron. "With the price of GBP/USD being 1.45, a put option of 1.40 was much more expensive than a call at 1.50 over the event. We realised we didn't have any model to interpolate this type of discontinuity."
The issue was compounded by the fact that clients were particularly interested in buying ‘wingy' put options – cheap bets to sell sterling well out-of-the-money (OTM), which could potentially yield a hefty return.
"This was the first time we had such a significant joint distortion in risky OTM and ATM (at-the-money) options. There was just such a level of disparity in expectation on what would happen on either side of the vote. Normally, with an event like this, we would add extra volatility into the curve, but that wasn't enough, as the cliff only got steeper to the downside as we got closer to June 23. We needed a way to keep business open and quote electronically to customers, so we had to enhance our interpolation tools in a short timeframe," says Charlie Chamberlain, director in forex options at HSBC.
"On the technical side, we have event weightings for given dates and can tweak the volatility curve. So for Brexit we created an additional way to put further dates into the system, where you could bend the interpolation around those dates for the volatility smile on top of doing it for ATM options. We essentially wanted to blend between a stair-step function and a linear one, but doing it in the risk reversal and the ATM. That was the core element of it," says Chamberlain.
New pricing system
The most pleasing element for HSBC was the time it took to recalculate its risk. From having initial discussions on April 19 between traders and quants, the team had its first test of the new pricing system ready the next day, and by April 22 it was up and running within a risk environment so traders could see their books with the smile bend in place.
"It's not so much that the quant methodology was groundbreaking, but it enabled us to capture the market and look at the risk very quickly. On May 9, we had released it into our distribution environment, which enabled us to keep quoting electronically over the period," says Chamberlain.
The end result was that HSBC was able to make markets more reliably during a period when liquidity was in high demand.
"We can be confident in providing consistent service to our client base before, during and after the event. That was one of the things we have been recognised for post-event. In large part, it was due to this change, as we had more confidence around what the price is and the ability to risk-manage off the positions we get from quoting our clients," says Ashwath Venkataraman, global head of forex options and commodities at HSBC.
The new pricing method proved so successful that HSBC decided to implement the same strategy in the run-up to the US presidential election, where USD/MXN was being used as a proxy for bets on who would win, and could yet use it for future elections.
"You couldn't just risk-manage your book like on a non-farm payroll day, because the distortion, the change of your position, the volatility of risk reversal, means the two outcomes are so different," says Passeron.
While HSBC's business in Europe and the US was centred on preparing for specific events, in Asia the most drastic change had already occurred in 2015, when the People's Bank of China deliberately devalued its currency, triggering a long-term trend in renminbi weakness.
Since August 2015, the currency has weakened from 6.20 to nearly 7.00 against the US dollar, reversing a long run of strength and fundamentally altering business in the region. The shift created a headache for Chinese corporates that have unhedged liabilities in US dollars, as well as those hedging cashflow using traditional target-redemption forwards (Tarfs).
You couldn't just risk-manage your book like on a non-farm payroll day, because the distortion, the change of your position, the volatility of risk reversal means the two outcomes are so different
Ashwath Venkataraman, HSBC
"As long as the renminbi kept strengthening against the US dollar, Chinese corporates wouldn't be worried about leaving their US dollar debt unhedged as it would be cheaper to pay down their liabilities. That perspective completely changes once the renminbi reverses course, because then you need to hedge the increased cost of paying back your US dollars," says Stephane Knauf, global head of forex and precious metals structuring at HSBC.
For those hedging liabilities, the simplest option was to roll the US dollar funding into renminbi via cross-currency swaps. Removing the currency risk typically comes with a trade-off in the form of increased funding costs, but HSBC offered clients the ability to manage this trade-off via structured swaps, giving them the chance to adjust the currency risk or cost of funding to their own objectives and risk appetite.
Typically, optionality is added to the coupons and/or the back-end notional exchange to do this. This can eventually reduce dealer charges for counterparty risk, funding and capital costs, or provide the possibility of participating in a strengthening local currency.
"If you look at Greater China as a whole, the amount of unhedged US dollar debt is enormous, so it is a big concern," says Knauf.
The demand for such solutions helped HSBC to grow this business by nearly eight times over in the first six months of 2016, hedging several billion of clients' US dollar debt in the process.
"Variations of this product have been successful in other emerging markets where the cost of funding is quite expensive. Corporates are looking to hedge their US dollar liabilities into local markets in anything with a high carry, and we've done bespoke trades to meet these needs in Turkey, Indonesia or the Philippines, for example," says Venkataraman.
The need to find new opportunities in the region was magnified by a drop in revenue from the bank's traditional Tarf business following the renminbi's devaluation. Tarfs are used by local corporates to hedge or speculate, typically selling a fixed amount of US dollars for renminbi at a specific level for the life of the trade – generally two years.
The target redemption feature means the product knocks out as soon as a certain level of profit has been earned, which worked well while the renminbi was steadily appreciating. A weaker Chinese currency, however, means corporates may be required to sell at the strike rate, regardless of how high spot moves. The end result has been a drop in revenue for some banks in the Asia region, but that is now being made up by the new US dollar liability hedging business.
"We're on the way to replacing the loss of revenue that was the Tarf business. It's something that happened quite abruptly. Three months after August 2015, suddenly a very mature business completely stopped. The new business we're doing is starting to become relevant and is something that can potentially grow into the void the other business left behind," says Venkataraman.
The diversification of new products meant HSBC's own risk profile has also changed. The bulk of flow with Chinese corporates typically left the bank long six-month vega, but the maturity of the business meant it was possible to find others that wanted to take the other side, allowing HSBC to hedge its positions, and recycle and manage the residual risk.
"What's happening now, as the product set switches from Tarfs to structured cross-currency swaps, is the kind of things we can offer to our institutional and hedge fund clients are different, and we're in the process of transitioning the liquidity from one set of products to another," says Venkataraman.