topic 04 futures & options 112 (1)
TRANSCRIPT
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FINC13-307INTERNATIONAL FINANCE
Topic 4
Foreign Exchange Risk Management: Part I
Reading Eun and Resnick Chapter 7, 8(Note: ensure you have read Chapter 3
of Eun and Resnick before class.)
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The aim of this lecture is to provide students with aninsight into some recent developments and issues in foreign
exchange risk (particularly transaction exposure) hedging.
Particularly this lecture will consider the issues of usingfutures and options to hedge foreign exchange risk
exposure, as well as the issues of hedge ratios and margin
hedging.
This chapter discusses various methods available for the
management of transaction exposure facing multinational
firms.
Aim
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Outline
Forward Market Hedge (see Topic 2)
Money Market Hedge (see Topic 3)
Future Market Hedge Options Market Hedge
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Future Market
Futures Contracts: Preliminaries
Currency Futures Markets
Futures Market Hedging
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Futures Contracts: Preliminaries
A futures contract is like a forward contract:
It specifies that a certain currency will be
exchanged for another at a specified time in the
future at prices specified today.
A futures contract is different from a forward
contract:
Futures are standardized contracts trading onorganized exchanges with daily resettlement
(known as marking to market ) through aclearinghouse.
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Futures Contracts: Preliminaries
Standardizing Features: Contract Size
Delivery Month
Daily resettlement
Initial performance bond (about 2 percent ofcontract value, cash or T-bills held in a street
name at your brokerage). Maintenance performance bond (about 75% of
the initial performance bond)
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Daily Resettlement: An Example (1)
Consider a long position in the CME Euro/U.S.
Dollar contract.
It is written on 125,000 and quoted in $ per .
The strike price is $1.30 the maturity is 3 months.
At initiation of the contract, the long posts an initial
performance bond of $6,500 (=125,000x1.3x0.04).
The maintenance performance bond is $4,000(=6,500x.75).
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Daily Resettlement: An Example (2)
Recall that an investor with a long position gainsfrom increases in the price of the underlying asset.
Our investor has agreed to BUY 125,000 at
$1.30 per euro in three months time. With a forward contract, at the end of three
months, if the euro was worth $1.24, he wouldlose $7,500 = ($1.24 $1.30) 125,000.
If instead at maturity the euro was worth $1.35,the counterparty to his forward contract wouldpay him $6,250 = ($1.35 $1.30) 125,000.
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Daily Resettlement: An Example (3)
With futures, we have daily resettlement of
gains an losses rather than one big settlement at
maturity.
Every trading day:
if the price goes down, the long pays the short
if the price goes up, the short pays the long
After the daily resettlement, each party has a
new contract at the new price with one-day-
shorter maturity.
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Performance Bond Money
Each days losses are subtracted from theinvestors account.
Each days gains are added to the account.
In this example, at initiation the long posts aninitial performance bond of $6,500.
The maintenance level is $4,000.
If this investor loses more than $2,500 he has adecision to make: he can maintain his long positiononly by adding more fundsif he fails to do so, hisposition will be closed out with an offsetting shortposition.
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Daily Resettlement: An Example (4)**
Over the first 3 days, the euro strengthens thendepreciates in dollar terms:
$1,250
$1,250
$1.31
$1.30
$1.27 $3,750
Gain/LossSettle
= ($1.31
$1.30)125,000
$7,750
$6,500
$2,750
Account Balance
= $6,500 + $1,250
On third day suppose our investor keeps his long
position open by posting an additional $3,750.
+ $3,750 = $6,500
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Daily Resettlement: An Example (5)
Over the next 2 days, the long keeps losing moneyand closes out his position at the end of day five.
$1,250
$1,250
$1.31
$1.30
$1.27$1.26
$1.24
$3,750$1,250
$2,500
Gain/LossSettle
$7,750
$6,500
$2,750 + $3,750 = $6,500$5,250
$2,750
Account Balance
= $6,500 $1,250
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Toting Up
At the end of his adventures, our investor hasthree ways of computing his gains and losses:Sum of daily gains and losses
$7,500 = $1,250 $1,250 $3,750 $1,250 $2,500Contract size times the difference between initialcontract price and last settlement price.
$7,500 = ($1.24/$1.30/)125,000
Ending balance on account minus beginning balance onaccount, adjusted for deposits or withdrawals.
$7,500 = $2,750 ($6,500 + $3,750)
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Daily Resettlement: An Example (6)
Total loss = $7,500
$1,250
$1,250
$1.31
$1.30
$1.27
$1.26
$1.24
$3,750
$1,250
$2,500
Gain/LossSettle
$7,750
$6,500
$2,750 + $3,750
$5,250
$2,750
Account Balance
= $2,750 ($6,500 + $3,750)
$$1.30 $6,500
= ($1.24 $1.30) 125,000
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Currency Futures Markets
The Chicago Mercantile Exchange (CME) is by
far the largest.
Others include:
The Philadelphia Board of Trade (PBOT)
The MidAmerica Commodities Exchange
The Tokyo International Financial Futures Exchange
The London International Financial Futures Exchange
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Reading Currency Futures Quotes
OPEN HIGH LOW SETTLE CHG
OPEN
INT
Euro/US Dollar (CME)125,000; $ per
1.4748 1.4830 1.4700 1.4777 .0028Mar 172,396
1.4737 1.4818 1.4693 1.4763 .0025Jun 2,266
Highest price that day
Lowest price that day
Closing price
Daily Change
Number of open contracts
Expirymonth
Opening price
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Basic Currency Futures Relationships
Open Interestrefers to the number of contracts
outstanding for a particular delivery month.
Open interest is a good proxy for demand for a
contract.
Some refer to open interest as the depth of the
market. The breadth of the market would be
how many different contracts (expiry month,currency) are outstanding.
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Futures In Australia
In Australia the main Foreign Exchange Futures Contract was the USD
contract traded on the Sydney Futures Exchange.
This contract was delisted on 24th September 1991, and re-listed on 6February 2001.
This contract has the following attributes:
CONTRACT SIZE: One Hundred Thousand Australian Dollars.
PRICE QUOTATIONS: The price is quoted in terms of USD per one AUD, theminimum price change is USD 0.0001
MINIMUM PRICE MOVEMENT: Minimum Price Movement is USD $0.0001 orUSD$10 per point.
CASH SETTLEMENT MONTHS: Every month up to Twelve (12) months ahead.
TERMINATION OF TRADING: The termination of Trading of each cash settlementis the third Wednesday of the month or other such time as the Board may determine.
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The Clearing House
In Futures Contracts the role of the CLEARING
HOUSE is to act as a guarantor for all contracts.
This acts to reduce the risk of the counterpartyto your contract defaulting.
The EXCHANGE provides a place for trading
and acts to 'referee' any disputes.
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Basis Risk (1)
As we are concerned with hedging, BASIS RISKis an important issue.
Due to the Transactions costs associated with the
Margin requirements and brokerage, it is notpossible to costlessly arbitrage between the
physical and futures markets.
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Basis Risk (2)
It is possible for the physical price implied by
a futures price to be different from the
physical market price, without an arbitrage
being possible.
This difference is usually limited to a small margin,
determined by the transactions costs.
The result is that at settlement date the physicalmarket price and futures market price can be slightly
out of alignment.
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Cash Neutrality
The aim of hedging with a futures contract is to be CASH
NEUTRAL.
The result is that a position in the physical market will be offset by
a position in the futures market.
As a rule an IMPORTER will BUY USD (foreign currency)
futures or SELL AUD (domestic currency) futures
An EXPORTER will SELL USD (foreign currency) futures or
BUY AUD (domestic currency) futures.
The aim will be for profits (losses) in the futures markets tooffset losses (profits) in the physical market.
Ignoring margin calls and marking to market.
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Using AUD Futures to Hedge FX Risk
The contract size is AUD 100,000, and ittrades as a direct quote in the US.
Thus the contract would trade as US cents per
Australian Dollar.
As futures contract price might be quoted as
1AUD = 0.6400 USD.
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Futures Hedging: Example 1 (1)**
An importer has just taken delivery of USD1,125,000
worth of Italian Car parts.
Under the terms of the trade financing provided the importer has 90
days to pay the USD.
The importer elects to use a futures contract to cover theexposure.
There is trading in Chicago a futures contract that also
matures in 90 days time. This maturation is assumed for the sake of convenience this rarely
occurs in practice.
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Futures Hedging: Example 1 (2)
Problem: the underlying exposure is written in
USD, however the CME futures contract is written
in AUD.
The (CME) AUD futures contract is currently
trading at 1AUD = 0.7500 USD.
Thus the USD is equivalent to AUD 1,500,000,using the futures prices
F t H d i E l 1 (3)
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Futures Hedging: Example 1 (3)
At time t=0
The importer SELLS 15 AUD contracts at
0.7500 (direct quote in the US).
These 15 contracts almost exactly hedge the
importer's exposure.
Note: This convenient symmetry is assumed, and
would rarely occur in practice.
As a result the importer expects to pay AUD1,500,00
for the USD in 90 days.
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Futures Hedging: Example 1 (4)At time t = 90 days
The Spot Rate is 1 AUD = 0.7143 USD. The futures contract trades at0.7142.
The following steps occur:
The importer closes out the futures contracts by buying15
AUD futures contracts at 0.7142 USD.
The CME will calculate profits / losses in USD as follows:
Return from selling 15 AUD contracts at 0.7500 = 1,500,000 AUD *
0.7500 = USD 1,125,00
Cost of buying 15 AUD contracts at 0.7142 = 1,500,000 AUD * 0.7142 =
USD 1,071,300
PROFIT IN USD = 1,125,00 - 1,071,300 = USD 53,700.
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Futures Hedging: Example 1 (6)At time t = 90 days
At the spot rate of 0.7143, the USD profit is equal to AUD
75,178.50
The importer buys USD 1,125,000 at the spot rate for a cost of
AUD 1,574,968.50.
After subtracting the profits from the futures contracts from the
costs in the spot market, the all up cost is AUD 1,499,790.
This is close to the expected cost, so the importer has generated
a cash - neutral hedge Note: The eventual cost of the USD is close to the estimated cost.
F t H d i E l 2 (1)
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Futures Hedging: Example 2 (1)FOR YOUR EXERCISE
An exporter has sold wheat and will receive10,000,000 USD in 60 days.
The price for the futures contract of the closest
maturity is 0.7600.
This contract matures eight working days after the
payment is due to be received.
At 0.7600, USD 10,000,000 is equivalent to AUD13,157,894.74.
Futures Hedging: Example 2 (2)
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Futures Hedging: Example 2 (2)At time t = 0
When using CME futures, the exporter canchoose to under-hedge by AUD 57,894 or
overhedge by AUD 42,106.
Each of these imply some risk taking / speculation bythe hedger.
The exporter decides to overhedge slightly and BUY
132 AUD futures contracts.
As a result the exporter expects to receive AUD 13,
157,894.74 for the USD.
Futures Hedging Example 2 (2)
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Futures Hedging Example 2 (2)
At time t = 60 days
The following happens:
1. The spot rate is 0.7550, while the futures
contract (with eight days to go) is 0.7542. Note: This difference between the futures price and
the spot rate is called 'the basis'.
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Futures Hedging Example 2 (3)At time t = 60 days2. The exporter closes out the futures position by selling 132
AUD futures contracts.
The Chicago Exchange calculates the exporters profits /
losses as follows:
Return from selling 132 AUD futures contracts at 0.7542 =
13,200,000 * 0.7542 = USD 9,955,440.
Costs of buying 132 AUD futures contracts at 0.7600 =13,200,000* 0.7600 = USD 10,032,000.
LOSSES IN USD = 9,955,440 - 10,032,000 = USD 76,560.
Futures Hedging Example 2 (3)
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Futures Hedging Example 2 (3)
At time t = 60 days
3. At the spot rate of 0.7550, the LOSS is equal to AUD101,403.97
4. The exporter sells the USD 10,000,000 at the spot
rate of 0.7550, to receive AUD 13,245,033.5. After allowing for the losses from the futures
position, the all in AUD income is AUD
13,143,629.03
Again the hedger is close to cash neutral, and has received
close to the AUD value implied by the futures contract at the
initial transaction.
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A number of issues:
1./ Why hedge?
2./ Problems from the inflexibility of futures
contracts.
3./ The Problem of Basis Risk.
1 / Wh H d ?
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1./ Why Hedge?
Given the outcome, particularly the spot rate,you may consider that hedging was not the
correct thing, as a greater return could have
been made if unhedged. However the exporter grows wheat, and is
not in the business of foreign exchange
speculation. The prospect of the potentially greater return is
only a certainty after the event.
2./ Problems from the inflexibility of
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2./ Problems from the inflexibility of
futures contracts.
An advantage of hedging in the US market is the greater
liquidity.
The fixed contract size results in the potential for over -
or under - hedging, as in Example 2.
The inflexibility of delivery dates can mean that the
maturity of the futures contracts does not match the
maturity of your exposure.
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2./ Problems from the inflexibility of
futures contracts (2)
The result of both these factors is that your have not got an
exact hedge, and so you do not know the exact outcome
until maturity date.
However you can usually estimate, to a few thousand
dollars, the outcome you are most likely to receive.
For the speculator futures are a popular instrument as they are highly
leveraged.
Futures exchanges encourage private individuals to trade in futures
contracts in order to generate liquidity in the market.
3 / The Problem of Basis Risk
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3./ The Problem of Basis Risk
The Chicago Board of Trade defines the basis as thearithmetic difference between the cash price and the
futures price of the same financial instrument, (cash minus
futures).
In the case of Example 2 the basis was 0.0008, or eight
points.
For financial futures the basis is usually positive, due to
the cost of carry. The cost of carry reflects theopportunity costs associated with using the physical
market to replicate the delivery of a futures contract.
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3./ The Problem of Basis Risk (2)
Futures contracts represent the present value of delivery of
the contract in the specified number of days time.
As interest rates are positive, the basis will be positive.
The basis is affected by the cost of carry, deliverable supply of theunderlying commodity, (not usually an issue in financial futures,
but important for the physical commodities), cost of delivery (that
is the cost of getting the commodity to market) and anticipated
interest rate changes (interest rate risk).
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Option Market
Currency Options Markets
Currency Futures Options
Option Market Hedging
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Options Contracts: Preliminaries (1)
An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset in the future, at prices agreed upon today.
Calls vs. Puts Call options gives the holder the right, but not the obligation, to
buy a given quantity of underlying asset at some time in thefuture, at prices agreed upon today.
Put options gives the holder the right, but not the obligation, tosell a given quantity of underlying asset at some time in the
future, at prices agreed upon today.
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Options Contracts: Preliminaries (2)
European vs. American options
European options can only be exercised on the
expiration date.
American options can be exercised at any time up toand including the expiration date.
Since this option to exercise early generally has value,
American options are usually worth more than
European options, other things equal.
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Options Contracts: Preliminaries (3)
In-the-money
An option that would be profitable if exercised
immediately and thus would have intrinsic value.
At-the-money The exercise price is equal to the spot price of the
underlying asset.
Out-of-the-money An option that would not be profitable if exercised
immediately.
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In At Out of the Money & Intrinsic Value
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In, At, Out of the Money & Intrinsic Value
Put Option Call Option In the Money Strike Price >Spot Rate Strike Price Spot
If the call is in-the-money, it is worth STE.
If the call is out-of-the-money, it is worthless.
CaT= CeT=Max[ST- E, 0] If the put is in-the-money, it is worthE - ST.
If the put is out-of-the-money, it is worthless.
PaT= PeT=Max[EST, 0]
Intrinsic
Value
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Options Contracts: Preliminaries (4)
Intrinsic Value
The difference between the exercise price of the
option and the spot price of the underlying asset.
Speculative Value The difference between the option premium and the
intrinsic value of the option.
OptionPremium
=Intrinsic
ValueSpeculative
Value+
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Basic Option Profit Profiles
E
ST
Profit
loss
c0 E+ c0
Long 1 call
If the call is in-the-
money, it is worth
ST
E.
If the call is out-of-the-money, it is
worthless and the
buyer of the call
loses his entireinvestment ofc0. In-the-moneyOut-of-the-money
Owner of the call
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Basic Option Profit Profiles
E
ST
Profit
loss
c0
E+ c0
short 1
call
If the call is in-the-
money, the writer
loses STE.
If the call is out-of-
the-money, the writer
keeps the option
premium.
In-the-moneyOut-of-the-money
Seller of the call
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Basic Option Profit Profiles
E
ST
Profit
loss
p0
Ep0 long 1 put
Ep0
If the put is in-the-money, it is
worthEST.
The maximum
gain isEp0
If the put is out-
of-the-money, it
is worthless and
the buyer of theput loses his
entire investment
ofp0.Out-of-the-moneyIn-the-money
Owner of the put
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Basic Option Profit Profiles
E
ST
Profit
loss
p0
Ep0 short 1 put
E + p0
If the put is in-the-money, it is
worthEST. The
maximum loss is
E + p0
If the put is out-
of-the-money, it
is worthless and
the seller of theput keeps the
option premium
ofp0.
Seller of the put
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Example
$1.50
ST
Profit
loss
$0.25
$1.75
Long 1 call
on 1 pound
Consider a call
option on 31,250.
The option premium
is $0.25 per The exercise price is
$1.50 per .
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Example
$1.50
ST
Profit
loss
$7,812.50
$1.75
Long 1 call
on 31,250
Consider a call
option on 31,250.
The option premium
is $0.25 per The exercise price is
$1.50 per .
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Example
$1.50
ST
Profit
loss
$42,187.50
$1.35 Long 1 puton 31,250
Consider a put
option on 31,250.
The option premium
is $0.15 per
The exercise price is
$1.50 per euro.
What is the maximum gain on this put option?
At what exchange rate do you break even?
$4,687.50
$42,187.50 = 31,250($1.50 $0.15)/
$4,687.50 = 31,250($0.15)/7-51
C O i
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Currency Options Markets
PHLX
HKFE
20-hour trading day.
OTC volume is much bigger than exchange
volume.
Trading is in six major currencies against the
U.S. dollar.
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PHLX Currency Option
S ifi i **
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Specifications**
Currency Contract Size
Australian dollar AD10,000
British pound 10,000Canadian dollar CAD10,000
Euro 10,000
Japanese yen 1,000,000Swiss franc SF10,000
http://www.phlx.com/products/xdc_specs.htm
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O ti M k t H d **
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Options Market Hedge**
Options provide a flexible hedge against thedownside, while preserving the upside potential.
To hedge a foreign currency payable buy calls
on the currency. If the currency appreciates, your call option lets you
buy the currency at the exercise price of the call.
To hedge a foreign currency receivable buy puts
on the currency. If the currency depreciates, your put option lets you
sell the currency for the exercise price.
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O ti M k t H d
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Options Market Hedge
$1.50/
Value of1 in $
in one year
Suppose theforward exchangerate is $1.50/.
If an importer who
owes 100m doesnot hedge the
payable, in one
year his gain (loss)
on the unhedged
position is shownin green.
$0
$1.20/ $1.80/
$30m
$30m
Unhedged
payable
The importer will be better off ifthe euro depreciates: he still buys
100m but at an exchange rate of
only $1.20/ he saves $30 million
relative to $1.50/
But he will be worse off if
the euro appreciates.
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O ti M k t H d
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Value of1 in $
in one year
Options Markets Hedge
Profit
loss
$5m
$1.45 /
Long call on100m
The payoff of theportfolio of a call
and a payable is
shown in red.
He can still profit
from decreases in
the exchange rate
below $1.45/ but
has a hedge againstunfavorable
increases in the
exchange rate.
$1.50/ Unhedged
payable
$1.20/
$25m
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$30 m
$1.80/Value of1 in $
in one year
Options Markets Hedge
Profit
loss
$5 m
$1.45/
Long call on100m
If the exchangerate increases to$1.80/ the
importer makes
$25 m on the call
but loses $30 m onthe payable for a
maximum loss of
$5 million.
This can bethought of as an
insurance
premium.
$1.50/ Unhedged
payable
$25 m
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Options Markets Hedge
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Options Markets Hedge
IMPORTERS who OWE
foreign currency in the
future should BUY
CALL OPTIONS. If the price of the currency goes up,
his call will lock in an upper limit
on the dollar cost of his imports. If the price of the currency goes
down, he will have the option to buy
the foreign currency at a lower
price.
EXPORTERS with accounts
receivable denominated in
foreign currency should BUY
PUT OPTIONS. If the price of the currency goes down, puts
will lock in a lower limit on the dollar
value of his exports. If the price of the currency goes up, he will
have the option to sell the foreign currency
at a higher price.
With an exercise price denominated in local currency
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Hedging Exports with Put Options
Show the portfolio payoff of an exporterwho is owed 1 million in one year.
The current one-year forward rate is 1 =
$2. Instead of entering into a short forward
contract, he buys a put option written on 1million with a maturity of one year and astrike price of 1 = $2. The cost of this option is $0.05 per pound.
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Options Market Hedge:Exporter buys a put option to protect the dollar
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61
S($/)360
$2m
$2
Long put
$1,950,000
$50k
value of his receivable.
$50k
$2.05
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The exporter who buys a put option to protect
the dollar value of his receivable
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62
S($/)360
$2
the dollar value of his receivable
$50k
$2.05
has essentially purchased a call.
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GAINForward Market Hedge:
Importer buys 1m forward.
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64LOSS
(TOTAL)
(TOTAL)
S($/)360
Long
currencyforward
Accounts Payable = Short
Currency position
p y
This forward hedgefixes the dollar value
of the payable at
$1.80m.$1.80
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$1.8m
Options Market Hedge:Importer buys call option on 1m.
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65
S($/)360
$1.80
Call
$80k
$1.88
$1,720,000
$1.72
Call option limits
thepotential cost of
servicing the payable.
p y p
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Our importer who buys a call to protect himself
from increases in the value of the pound creates a
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66
S($/)360
$1.80
$1,720,000
$1.72
p
synthetic put option on the pound.
He makes money if the pound falls in value.
$80k
The cost of this insurance policy is $80,000
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The Hedge Ratio**
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In the example just previous, we replicated the
payoffs of the call option with a leveredposition in the underlying asset. (In this case,borrowing dollars to buy euro at the spot.)
This ratio gives the number of units of the underlyingasset we should hold for each call option we sell inorder to create a riskless hedge.
The hedge ratio of a option is the ratio of change in
the price of the option to the change in the price of
the underlying asset:
H =C CS1 S1
downup
downup
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Hedge Ratio
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Hedge Ratio This practice of the construction of a riskless
hedge is called delta hedging.
The delta of a call option is positive.
Recall from the example:
The delta of a put option is negative.Deltas change through time.
H =C CS1 S1
downup
downup
$0.375 $0
$1.875 $1.20
$0.375
$0.675
5
9= ==
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