Hedge Currency Payables with a
Purchased Double Knock Out Call
• Limited Benefit to OTM Strike
• Upfront Premium Lower than Vanilla Call
and Single Knock Out
• Risk of Lost Hedge if Spot Reaches Either
RBC Capital Markets
Profile of a Double Knock Out Call Option
to Hedge Currency Payables
A double knock out call option has some of the features
of a vanilla call option. It allows a buyer the right, but not
the obligation, to buy a fixed amount of one currency for
another at a set strike price on a specific future date.
However, the defining features, two knock out triggers,
render the option null and void if spot reaches a
predetermined level any time on or before expiration.
The premium of a double knock out option generally
costs less than the premium for a vanilla call and a
single knock out if all three have the same strike.
Unlike a spot or forward transaction, the buyer of the call
is not obligated to buy the underlying currency. If spot
never reaches either knock out trigger and is below the
strike at expiration, the holder of the call will exercise
and buy currency at the strike. However, if the option
hasn't been knocked out and spot is below the call strike
at expiry, the holder will not exercise the call and can
buy currency at the more advantageous spot rate.
Double Knock Out Options as a Hedge
A holder of a currency payable would purchase a double
knock out call to hedge against a currency’s appreciation
while allowing for limited benefit from the currency’s
depreciation. In exchange for a reduced premium, the
buyer assumes risk that the currency may either
depreciate or appreciate to the knock out levels and then
expire with losses that otherwise may have been
protected. If the currency never reaches a trigger, the
value of the option will offset a currency move above the
strike at expiration.
As the knock out triggers are set closer to the forward,