FX Link can be used to replace an OTC FX spot delta hedge of an exchange-listed FX option transaction for enhanced margin management.
Scenario
A bank sells at-the-money (ATM) put options on the JPY/ USD futures contract from CME Group. The bank seeks to delta hedge the short ATM put options against price movements in JPY versus USD to create a delta-neutral portfolio that will profit from the implied volatility and/or time decay of the short ATM put option position.
OTC approach
- Execute a delta hedge by buying spot USD/JPY in the OTC market in an amount equal to the delta of the short ATM JPY/USD put option position to create a delta-neutral portfolio.*
- Separately execute two transactions, resulting in applicable prime broker (PB) and exchange fees, with potential execution risk and the cost of crossing the bid-ask spread twice.
- This strategy introduces basis risk and forward risk to the delta hedge, because the underlying instrument of the option is a FX futures contract and not spot FX.
FX Link approach
- To replace an OTC USD/JPY spot delta hedge of the short ATM put option position, the bank could buy the USD/JPY FX Link spread – i.e., selling a delta-equivalent IMM-dated JPY/USD futures position while simultaneously selling an offsetting delta-equivalent OTC USD/JPY spot position.
- Effectively replaces the OTC USD/JPY spot position with a delta-equivalent IMM-dated JPY/USD futures position.
- Receives full central clearing party benefits and portfolio netting of futures and options, leading to optimized margin requirement and lower funding requirements.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
