Deal Contingent Hedging

3. Pricing

Author: Federico Bellanti

February 12, 2024

Pricing components

In our previous discussions, we delved into the basics of Deal Contingent Hedging and provided a snapshot of the typical contractual clauses found in a DCH Long Form Confirmation. Now, we turn our attention to a particularly intriguing aspect of DCH: its cost.

Indeed, the cost question is highly relevant. With DCH, companies gain a level of flexibility not offered by traditional hedging methods, such as Forwards or Interest Rate Swaps. Naturally, this added flexibility comes at a price.

Let's start by saying that a "formula" (more or less financially proven) for DCH pricing does not exist. We can, as is often done in the field of finance, establish the "boundaries", i.e. the minimum and maximum within which the correct pricing will be found.

For an FX Forward Deal Contingent, the baseline or "floor" price would be that of a standard FX Forward: since DCH provides additional benefits, its cost will not be lower than a traditional Forward. The same logic applies to Interest Rate Swaps; their pricing will not be more favorable than that of a classic fixed-floating swap.

The "ceiling" price is determined by the non-refundable cost of an "At-the-money-forward" option for FX, or an at-the-money Swaption for rate transactions. This is because purchasing an option gives the buyer complete flexibility, albeit at a full, non-refundable cost.

Historically, DCH pricing was initially based on a probabilistic approach, combining the likelihood of the underlying deal's success with potential profits or losses tied to market fluctuations. However, the market quickly shifted towards a more practical strategy, reflecting how traders manage the inherent uncertainty of these risks.

Pricing for DC on a Foreign Exchange

For standardized FX Deal Contingent transactions, the premium over a traditional FX forward is normally a fraction (15 to 40%) of the cost of a vanilla option, with the strike price set at the forward rate and maturity matching the DCH. The type of client, such as Private Equity versus Corporate companies, also influences pricing, with the former typically seen as statistically having a higher likelihood of success and thus receiving more favorable rates.

Let's examine a hypothetical scenario based on market prices from February 9, 2024.

Imagine Company XYZ, based in the Eurozone, needs to buy US Dollars in six months and opts for a DC Forward. The bank sets the price at 30% of a Vanilla option.


Spot EUR/USD	1.0781
6 month Swap Points	80
Forward EUR/USD 6 months	1.0861
Volatility ATMF 6 months	6.37%
Option Price (USD pips)	191
DC Margin (30%)	57.3
Deal Contingent Forward PRICING:	1.08037

As you can see, in this specific example the price of the DC Forward (1.08037), although more expensive than the traditional Forward (1.0861), is here a bit more favorable than the current spot exchange rate (1.0781). Obviously this is not always the case.

This pricing strategy, while not strictly scientific, allows for the integration of various market and other factors into the instrument's price, including:

The rate differential between the two currencies: taken care of by the FX Forward.
The higher or lower volatility of the currency: taken care of by the option's price. Higher volatility increases the option's premium and, consequently, the DC's cost.
The probability of success: is reflected into the % of Vanilla price agreed upon with the bank

Pricing for DC on interest rates

Pricing for Interest Rate Deal Contingent transactions is a bit more complex, with two primary scenarios:

Cash settlement at the Settlement Date, often used when the underlying deal's funding is secured at a fixed rate, eliminating the need for a swap.
Activation of a Fixed-Floating swap upon deal completion for a set duration.

In the first scenario, pricing of the DCS is based on the price of a Forward Starting Interest Rate Swap, plus a percentage of a vanilla option's price (a Payer Swaption). For highly standardized contracts with a strong chance of success, this percentage ranges between 30 and 45%.

The second scenario accounts for additional factors, including the credit risk and capital absorption the swap imposes on the bank, necessitating an adjustment to the vanilla option percentage. This means XVA (credit + funding + RWA adjustment) will be added on top: these components will depend on a number of factors including the borrower's credit quality, the hedging bank's access to the security package, any structural or legal subordination, any collateral agreement being setup, just to mention some.

Over time, we can expect the evolution of DCH pricing methods, influenced by new market entrants capable of efficiently managing these risks. Hedge Funds and certain ReInsurance companies, for example, might assess the risk-return profile differently, potentially leading to pricing based on alternative factors. Already, these players are engaging with banks' Deal Contingent portfolios, buying into the risk and thereby enabling banks to free up capacity for new deals.