The effects of built-in premium on the outcome of “Zero-Premium” FX options strategies

Abstract

This research aims to understand the effects that the built-in premium has on the outcome of foreign exchange option strategies which are known to be ‘Premium-free’. Such strategies are offered to clients without any upfront premium and may result in a loss if a certain level is breached during a stipulated period of time, or at expiry. This analysis is based on a 7-year back testing model using two main strategies – the ‘Window Forward Extra’ and the ‘At Expiry Forward Extra’. Furthermore, back tests were performed using 3 currency pairs, namely EURUSD, EURGBP and EURJPY. Results show that in most cases there was no effect on the outcome of the strategy by an increase in built-in premium. However, the minimal effects are statistically significant when the whole sample is taken into consideration. Therefore, one may conclude that when considering the whole period, there does seem to be an effect on the outcome of the strategy by an increase in built-in premium. When such strategies were tested for speculative purposes, it was found that brokers, in the majority of cases, are better off taking additional risk and receiving a premium upfront rather than benefitting from a more attractive barrier level. Furthermore, portfolios were created using FX option strategies, FX spot and FX forwards. After analysing such portfolios it was found that the optimal strategies in all cases were the FX option strategies. The portfolios’ risk was analysed which indicated that optimal portfolios do not necessarily derive the lowest risk. The EURUSD portfolios were also analysed and compared with the VIX level in order to see whether volatility has a direct effect on the outcome of the strategies. It was found that with a high VIX level, the forward contract was the most beneficial whilst the option strategy benefited from a low VIX level. Nevertheless, the option strategy was the most beneficial when taking into consideration the whole period under analysis. The histogram and distribution curve of each portfolio were created and plotted in order to provide a more visual analysis of returns. Although some similarities were noticed, distribution curves differed from the normal distribution. Kurtosis analysis was also performed on the portfolios. Most kurtosis levels differed from that of a normal distribution which has a kurtosis level of 3. Interpretation of such histograms, distribution curves and the kurtosis analysis were explained. In this text one finds six main chapters, namely, the introduction chapter which explains the motivation behind this research; the research hypothesis and a priori expectations chapter which highlights the empirical questions that this analysis aims to answer together with a priori expected results for such questions. Furthermore, literature review on the subject, with special attention to FX options is provided in detail. The methodology chapter gives a step-by-step explanation as to how this study was conducted which includes several stages of this research such as back-testing using the Bloomberg Terminal and programming using MatLab. The empirical findings chapter explains all the research findings and their interpretation in detail, whilst this analysis is concluded by looking at the overall results achieved from this research and providing recommendations for further studies and professionals within the FX options industry.