The Leveraged Collar That Was Called Free
You are an FX structuring analyst at a bank. A French industrial group with a $90 million payable due in 12 months asks for protection against EUR/USD falling below 1.0500 but refuses to pay an upfront premium. Your structurer proposes a leveraged collar: the client buys a EUR put/USD call at 1.0500 and sells a EUR call/USD put at 1.1200 on twice the notional ($180 million). There is no knock-out. The treasurer, who is an elective professional client, says the structure is "free" and asks you to confirm that the maximum cost is the premium he is not paying. Spot is 1.0870; 12-month implied volatility is 7.2%; a plain vanilla 1.0500 put costs 2.1% of notional and a 1.1200 call on the same notional is worth 1.9%. The group's board has a policy that hedging instruments must not create obligations exceeding the hedged exposure.
1. Calculate the client's position at EUR/USD 1.1800 and at 1.0200, and state the maximum loss. Is the treasurer's understanding of the maximum cost correct?
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At 1.1800 the bought 1.0500 put on $90m is out of the money and expires worthless. The sold 1.1200 call is in the money on the doubled notional: (1.1800 − 1.1200) × $180m = $10.8m payable by the client. The commercial payable improves because a stronger euro means fewer euros are needed to buy the $90m (about €76.3m at 1.18 versus €85.7m at 1.05), but that gain only covers the exposure once; the extra $90m of sold notional is a naked position.
At 1.0200 the sold call expires worthless and the put pays (1.0500 − 1.0200) × $90m = $2.7m to the client, which offsets the weaker euro on the payable.
The treasurer is wrong. The maximum cost is not zero: above 1.1200 the client is short a call on $90m of notional that it does not own, and the loss is theoretically unlimited. At 1.3000 the derivative loss would be $32.4m, far exceeding the commercial benefit. "Zero premium" describes the cash flow at inception, not the risk profile.
2. What suitability, disclosure and conduct issues arise from the treasurer's request and the board policy?
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The board policy is the decisive constraint: a structure that can create obligations larger than the hedged exposure is outside the client's stated mandate. Recommending it would fail the duty to act in the client's best interests, even though the treasurer is an elective professional client. Elective professional status reduces certain protections but does not permit the bank to sell a product that contradicts the client's own risk limits without challenge.
The bank must provide a fair, clear and not misleading description, including scenario analysis at 1.0200, 1.1200 and 1.1800, an explicit statement that the maximum loss on the sold call is unbounded, and details of collateral and margin calls if the position moves against the client. The written appropriateness assessment should record that the client has no need for a speculative position and that the over-hedge is inconsistent with the policy. If the client still insists, the bank should escalate rather than process as routine; execution-only handling should be documented, and the structurer's incentive to book the trade should be recognised as a conflict.
3. Propose an alternative within the board policy and compare it with the leveraged collar.
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A same-notional zero-cost collar fits the policy: buy the 1.0500 put on $90m and sell a 1.1200 call on $90m only. At the quoted prices the call is worth 1.9% versus the put's 2.1%, so the cap can be set slightly lower, around 1.1350–1.1400, or the client accepts a small residual premium. The maximum obligation is the hedged $90m; if EUR/USD rallies sharply the client forgoes gains above the cap but does not make a loss.
A participating forward is a second option: the client commits to a rate and participates in, say, 50% of any favourable move, with no levered leg. It gives less protection than the collar in a sharp fall but preserves some upside.
Compared with the leveraged collar, both alternatives remove the unlimited tail, satisfy the board policy and are simpler to explain. The trade-off is a lower cap or a partial hedge; that is the correct price of removing the speculative leg. Recommend the same-notional collar, with a documented scenario analysis and a clear statement of the cap level the client is accepting.