Eleven Years Later, Highly-Leveraged Short Vol Trades Still Going Horrifically Wrong For Everyone Involved

Back in 2014, clients and banks in Hong Kong got carried out backward when a sharp move in USDCNH blew up clients who’d unwisely bought Target Redemption Forwards (henceforth TARFs). I wrote about it at the time, and republished the piece here a year later. The conclusion was that TARFs are a terrible trade for everyone involved: clients will inevitably blow up because they’re leveraged short low-delta wings, and bank exotics desks will blow up because these things are a cast-iron bastard to properly hedge¹.

The frustrating thing for me is that this wasn’t the first time, or even the second time, I’d seen clients blown up in the exact same way by the exact same trade. In 2007, TARFs were all the rage amongst Taiwanese importers who wanted to hedge against a weakening TWD; in February 2008, TWD abruptly strengthened instead, and my sales desk had clients crying on the phone asking for get-out prices for TARFs that other banks had sold them. And in October 2008, CITIC Pacific lost USD 2 billion when AUD dropped from 80 cents to 60 cents in the space of a month and blew a hole in the side of the ten yards of AUDUSD TARFs they’d bought as a “hedge”. CITIC Pacific only survived because of a ten-figure bailout from its parent company, and FX derivatives sales teams should have learned a lesson.

From the fact that I’m writing this, you can guess that they haven’t. UBS has disclosed making “goodwill” payments to over a hundred wealth-management clients who were run over post-Liberation Day on “Range Target Profit Forwards”, a subspecies of TARF. And the payments aren’t small: there’ve been reports of the payments amounting to 50–90% of the losses that these customers incurred on their trades.

At this point I genuinely don’t understand why derivatives sales teams continue to sell these things—or, for that matter, why their risk teams allow them to sell these things. Nineteen times out of twenty, the client walks away with a small cash payment, so the clients keep doing the trade until the zero hits on the roulette wheel and they blow up. And these things are lucrative upfront for the bank as well², so banks where the sales culture is stronger than the risk culture are willing to keep printing the trade and booking the upfront profit. Strong risk teams, though, should know that the end result of a large TARF book will be, firstly, a horrendous mess of hedging if the TARFs ever go in the money; and, secondly, lawsuits.

I’m also left wondering why corporates continue to buy these things. There have been so many TARF blowups in the last two decades that if you’re a corporate treasurer who’s buying TARFs on a regular basis, you have no excuse for not knowing how it’s going to end. If you’re a CFO whose finance team is printing TARF after TARF after TARF and claiming they’re doing it to hedge their FX exposure, you should start asking questions.

And if you’re an inquisitive journo, you might be well placed to ask those questions too. A good place to start might be the European defense contractor that’s started printing TARFs in enough size to move the EURUSD FX options market.