Bafman Strategy –   There is No Such Thing as a Free Lunch

Recently, many companies received a proposal from the banks to hedge their foreign currency exposure through Bafman strategy (Bafman = Bonus Forward Leveraged Faded)

Before openly embracing Bafman, which has just “made Aliyah” after being formulated by the best financial engineers abroad, it is important to examine the quality of the hedge it provides for the company as well as the cash flow and accounting implications of its use. The analysis below examines these issues.

The Bafman is a structured product, consisting essentially of buying a series of exotic Put options that include Knock-Out-Trigger, for different value dates but with identical exercise prices and amounts, simultaneously with the sale of a series of exotic Call options at exercise prices, value dates and identical Knock-Out-Trigger to the Put options that were purchased, but at double the amount.

For the purpose of explanation, let us assume that an exporter received from the bank a proposal of “Bafman” strategy in USDILS according to the following details:

Market rate: 3.46

Transaction period: A year

Samples: 12 monthly samples, on the last business day of every month

Strike price: 3.50

Knock-Out trigger: 3.20

Sum of transaction: 1-2 million dollars in every selection (1:2 ratio)

* For comparison, we’ll assume that the average forward rate for the appointed samples is 3.42.

The possible results of this transaction for each sample date are:

  1. In the event that the exchange rate prior to the sample date is traded above the level of 3.20 (the Knock-Out event did not take place):
    • If the exchange rate is higher than 3.50 on the sample date -> the company will sell 2 million USD against the ILS at the exchange rate of 3.50.
    • If the exchange rate is lower than 3.50 on the sample date -> the company will sell a million USD against the ILS at the exchange rate of 3.50.
  2. In the event that the exchange rate, during the life span of the strategy, is traded at a level equal to or less than 3.20 (the Knock-Out event took place), the transaction ends immediately, meaning that the options for distant sample dates are canceled.

The advantage of the Bafman strategy is that it allows, supposedly, to create a series of synthetic forward transactions at a rate higher than the rate obtained in standard forward transactions in the same market conditions (3.50 as opposed to 3.42, in the example above).

This advantage is obtained by combining two components:

1. Leverage – The sale of the Call options is, as stated, twice the amount at which the Put options are purchased.

2. The Knock-Out of the purchased Put options significantly reduces the price of the options, compared to the Knock-Out of the Call options sold.

With that, the “bait” of a higher exchange rate figure, has many disadvantages:

1. In the event of a sharp ILS re-evaluation, the company does not have a hedge at all – at a time when the market conditions are significantly working towards the disadvantage of the company (an exchange rate lower than or equal to 3.20), and when protection is most needed, the transaction is null and void. In this way the company of transgresses the whole hedging process, which is exactly the purpose for which it carries out protections in the first place (protection of the future cash flow of the company and especially from “catastrophic” situations). It is similar to medical insurance that provides medical coverage for the treatment of common and easy cured illnesses such as angina or colds, but leaves the insured alone in any, more complex medical procedures…


2. The protection exists only on half the amount of the transaction – based on the example above, the volume of the transaction is actually 24 million USD, whereas the protection against the exchange rate decline is only about 12 million USD. The symmetry that exists in a standard forward transaction or in a Risk Reversal (Cylinder) strategy does not exist in the above case, and the volume of USD that the company sells is actually conditional to the market rate.


3. The execution of one transaction at a significant volume – The Bafman is usually executed in relatively large amounts, so that the company simultaneously defines a significant amount of its exposure.
One of the principles in hedging activity is to gradually hedge the exposure and not to carry out dramatic measures that creates a “zero or hero” scenarios


4. Lack of transparency in hedge activity- The use of complex financial instruments such as the Bafman, may cause a situation in which the cash flow and accounting implications of the hedge transaction are not clear to the management level of the company and the Board of Directors. The reality proves that the above mentioned becomes clear too late, after the company has been subjected to a significant cash flow/accounting loss.


5. Difficulty in producing fair value for a transaction – The more complex the transaction, the more difficult it is to calculate an objective fair value required for the purpose of the financial statements.


6. High volatility in financing expenses – The changes in the fair value of the transaction are recorded in the financing expenses (even if the company implements hedge accounting on an ongoing basis, it will not be able to do so in respect to the Bafman strategy). Since the transaction is executed for a large amount and for a relatively long period of time, the periodic changes in fair value may be significant and can cause high volatility in financing expenses.


7. Deviation from the policy approved by the Board of Directors –Although the term forward is part of the word Bafman, it is far from it. In fact, it is an exotic tool that combines a synthetic Forward (with Knock-Out) and the sale of a call option, which is generally prohibited in the company’s hedge/investment policy.


Attached is a paragraph from an article written by the International Monetary Fund (IMF) that included empirical research on the use of exotic tools for hedging purposes:

“In discussing the unsuitability of exotic derivatives for either hedging or speculation, three key points need to be made:
First, exotic derivatives are not appropriate hedging instruments because they do not closely match the existing risk exposures of the non-financial firms. While in most cases the firms do need to hedge against an appreciation in the local currency, the KIKO and TARN instruments do not function as a hedge if the currency appreciates sufficiently to knock-out or trigger a redemption of the contracts. Moreover, the firms’ exposure to a currency depreciation, which is normally beneficial to the exporting firm by making its products more competitive, is not matched by the doubling of the rate of derivatives losses from currency depreciation.
Second, the instruments are not appropriate because the firms are not capable of absorbing the potential losses that can occur from a ‘geared’ or double-size notional principal used to calculate losses on the downside. One of the fundamental principles of suitability is that the investor should be capable of absorbing potential losses from a financial instrument.
Third, if the firm in the tradable goods sector intended to speculate, these were clearly not the best instruments to use for speculation. Either a currency futures or standard forward or swap would offer the same or better potential gains on the upside—it would be better in that it would not be knocked out—while not exposing the speculator to double the downside risks.”

“Exotic Derivatives Losses in Emerging Markets: Questions of Suitability, Concerns for Stability”, IMF, July 2009