Download - Topic 04 Futures & Options 112 (1)

8/3/2019 Topic 04 Futures & Options 112 (1)

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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

1 of 52


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Outline

Forward Market Hedge (see Topic 2)

Money Market Hedge (see Topic 3)

Future Market Hedge Options Market Hedge

8-2


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Future Market

Futures Contracts: Preliminaries

Currency Futures Markets

Futures Market Hedging

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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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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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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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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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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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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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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.



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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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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.



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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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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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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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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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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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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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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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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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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 .

7-50


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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 **
http://www.phlx.com/products/http://www.phlx.com/products/


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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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O ti M k t H d


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$30 m

$1.80/Value of1 in $

in one year


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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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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